Core-And-Explore ETF Portfolios Combine Best Of Index & Active Investing

There are plenty of ways to allocate a portfolio, including the core-and-explore approach. This investment philosophy combines the best traits of index funds with the added benefit of theme, sector or actively managed funds.

Core-and-satellite injects the discipline of asset allocation with the opportunity to add alpha, which could increase your return beyond that of the broader global market.

Numerous academic studies have shown that asset allocation accounts for the bulk of portfolio outcomes. In other words, that means constructing a portfolio that includes deliberately chosen stock-and-bond assets, allocated in specific percentages with an eye on the return needed to meet your financial goals.

That’s a far cry from a willy-nilly collection of “stuff,” which is something I often saw when new clients would come to my advisory firm. 

Market-timing and stock picking can absolutely drive short- to medium-term gains. If you have patience and confidence in a stock you can even sit through normal corrections and hold it for years. 

Focus On Core Allocation First

However, over the long haul your core allocation is more important. That’s because unlike single stocks, it’s easier to develop a portfolio with an expected return and risk profile. That helps you plan your retirement income. Single stocks are much more volatile than even a basket of equity ETFs, which inherently have some diversification. 

Given that, how should you implement a core-and-satellite portfolio if you want to take advantage of more active management with the reliability and cost-effectiveness of indexes?

Start with your risk profile analysis. I emphasize this a lot when writing about portfolio construction, but it’s absolutely crucial if you want your retirement nest egg to last as long as you do. Many Americans underestimate the amount they will need to retire, because they also underestimate their spending, and don’t connect the dots between income and expenses. 

The core-satellite balance between active management and index investing begins with decisions about the proportion of core assets you’ll allocate to index or passive funds. That’s where you allocate according to your risk tolerance. 

(As an aside, having a “high” risk tolerance is not some badge of honor. Risk tolerance is dependent on a number of factors, including your time horizon and investable assets. I can’t tell you how many clients fancied themselves as having high risk tolerance, but panicked when the market declined, which is exactly the opposite of a high risk tolerance.) 

Different Approaches To Exploration

Your mix of index and theme or active investments may differ across sectors. For example, You may own a plain-vanilla S&P 500 index fund such as the Vanguard S&P 500 ETF (VOO), but you want to add some alpha with high-growth tech stocks. In that case, perhaps the actively managed ARK Innovation ETF NYSEARCA: ARKK  may juice up your return. However, even that type of hot investment isn’t foolproof; while the ARKK ETF returned 152.82% in 2020, but is down 6.24% this year.

That’s where the tactical nature of “core and explore” comes in. If your tactical allocations are mired in a slump, you may want to sell and plow the money into something that’s performing well, or invest in a different theme. 

Also be careful if you believe a theme is hot and destined to rocket higher. For example, among the growing number crypto ETFs currently available, most are currently in a correction and may not be at ideal buy points. 

Core-and-explore is a great way for investors who want the ease and generally greater predictability of index funds, but who also want to capitalize on assets currently outperforming or who may want to explore a conviction about a certain area of the market. 

There are multiple ways you can build out the “explore” portion of your portfolio. For example, you don’t have to only use active or theme ETFs; you could include sector indexes to add alpha, such as the Energy Select Sector SPDR Fund NYSEARCA: XLE, which is the leading S&P 500 sector ETF in the past three months.