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The new investment strategy that’s better than index funds

Core plus satellite could be a winning investment strategy. Photo: AP Photo/ESA/HOYou’ve probably come across the term “index tracking” – I’ve written about it extensively in this column.

At its simplest, it’s buying the returns of the market cheaply. The idea has been around for a very long time, but it’s the advent of exchange traded funds (ETFs) that has made index investing popular.

ETFs track the returns of all sorts of markets and are listed on the n sharemarket with units in them bought and sold just like shares.

And they are cheap with management fees a fraction of a per cent.

However, there is a danger that anyone who buys an ETF that tracks the n sharemarket, for example, ends up investing in the 10 or so largest stocks by market capitalisation – the stocks that dominate our market.

The n sharemarket is top-heavy by international standards; a few large stocks at the top with a long tail of minnow stocks.

Investing in an ETF tracking the largest 200 n-listed companies means investing in the big banks and the big miners – hardly a diversified investment strategy.

But there is an idea called core plus satellite – where there’s a core of low-cost index trackers with satellites added – that may give investors the best solution of all.

The satellites could be those active managers who have a good chance of more than earning their fees as study after study shows that most don’t earn their fees.

They could be shares themselves – growth shares for those who are still accumulating their savings and want share price growth, or income stocks, the big dividend payers for those who need income.

I asked Tim Murphy, director of manager research at investment researcher Morningstar, how the strategy could work in practice.

He says the actual splits between core and satellite will depend on the asset class and the growth versus defensive split based on investors’ personal circumstances, which is why financial advice is recommended.

Murphy says, in terms of the satellites, funds that invest in smaller n companies have a better track record than other types of share funds in adding value after fees.

Most trustees of self managed super funds prefer to use direct investments, and especially listed investments rather than unlisted managed funds.

Of the n shares component, there could be a core of, say, 70 per cent and satellites worth 30 per cent, Murphy says.

Instead of ETFs, the core n shares exposure could be one of the big listed investment companies (LICs), such as n Foundation Investment Company (AFIC) or Argo Investments.

These big LICs pay fairly steady dividends. And while they are active managers, these older LICs are managed conservatively with costs that are comparable to ETFs.

Sometimes LIC share prices can get out of whack with the value of the underlying portfolio.

That means that the share price can move above or below the value of the portfolio holdings and so care has to be taken when buying and selling shares in them.

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