Core Versus Satellite: How Much Should a Taxable Investor Allocate to the Core Equity Portfolio?

T he core-satellite structure is a common portfolio construction approach used widely for taxable clients. Under this approach, a "core" portfolio is invested in a passive index-tracking mandate, while high-conviction active managers who seek to outperform the equity-market index manage a number of smaller "satellite" portfolios. This approach has been widely noted for its fee, risk, and tax efficiencies (Stein [2001]).

Compared with a portfolio of active managers, the core-satellite structure is normally less expensive in terms of management fees, given the bulk of the assets are in a low-fee passive mandate. This structure allows more flexibility, as the overall fee-budget for the portfolio can be met, while still allowing even relatively pricey alpha-seeking satellites.

In terms of allocating an active risk budget, many advisors find that the use of a core-satellite structure allows most of the risk budget to be focused on the smaller satellite managers. In this way, more discretion in the form of a higher-tracking-error allowance can be given to those managers who the advisor is most confident can attain the highest levels of alpha, while keeping the tracking error of the overall portfolio relatively modest. In addition, given the predictability of the core portfolio, risk monitoring can be focused on the handful of satellite managers, rather than trying to monitor a variety of active managers across a number of asset classes.

A core-satellite structure can be remarkably tax-efficient, especially if the core portion of the portfolio is tax-managed. That is because the passive manager is allowed to opportunistically harvest losses and defer short-term gains subject to a modest tracking-error budget. The losses harvested by such a "tax-managed core" mandate could be used to offset the taxable gains generated by the satellite managers. In this way, the core-satellite structure offers the potential to greatly increase after-tax returns. Given these efficiencies, it is no surprise that the core-satellite structure has gained in popularity over the years.

Once advisors have decided to use a core-satellite structure, however, a natural question to ask is how much of the portfolio a taxable investor should allocate to the core. Generally, the more talented the satellite managers, the smaller the allocation to the core should be. Conventional wisdom places the core allocation at only 20% to 25%...