“The individual investor should act consistently as an investor and not as a speculator” - Benjamin Graham
As an expat investor, there are different strategic approaches to investing. Core and Satellite is an investment strategy that aims to strike a balance between reducing risk and maximising gains when building a portfolio.
Specifically, in this article, you’ll learn about the following topics:
• What is a Core and Satellite investment strategy?
• What are the benefits of Core and Satellite?
• Types of core investments
• Balance of Core and Satellite
• US tax matters
What is a Core and Satellite investment strategy?
The Core and Satellite investment approach involves splitting your investments in two portions:
(i) a larger portion called Core, which is the foundation of your investments, typically being a safer portion of your portfolio whose performance will track markets in general. Usually the Core is made up of low-cost passive investments, such as index funds and ETFs.
(ii) a smaller portion called Satellite, which are targeted investments to complement the Core, commonly being a riskier part of the portfolio with potential to achieve higher gains. Usually the Satellite is made up of thematic investments, individual stocks and actively managed funds.
What are the benefits of Core and Satellite?
Core and Satellite is a tried and tested investment approach, and it is always popular due to its several integral benefits:
• Reduced costs and potential to achieve tax savings. There are two ways that savings are made with a Core and Satellite investment approach. The first is because the core part of the portfolio isn’t actively managed, thus reducing transaction and management fees. Secondly, because the core part doesn’t involve actively managed regular buying and selling, there’s potential to achieve savings on taxes relating to gains, which are taxed as income if bought and sold in the same year, or as a capital gain if the investment was held for over a year before being sold.
• Potential to outperform benchmarks. The Satellite holdings, which are more focused and can be actively managed or targeted towards specific themes, have the potential to outperform the broader market. Investors can capitalize on investment opportunities they believe in or benefit from active management expertise in specific areas while still capturing the market's overall performance through the core portfolio.
• Risk mitigation. Conversely, the core reduced the overall risk of the portfolio compared to a totally actively-managed investment approach.
• Portfolio diversification. Core-and-satellite allows for natural diversification, as the core part of the portfolio typically covers a range of equities, rather than a small handful of individual stocks.
Types of Core investments
Core investments are meant to be defensive, so they are placed in a fund that contains a broad range of equities so that the performance tracks overall market performance. These are typically index funds.
What is an index fund? Index funds track a particular index, such as the S&P 500. They normally contain a large number of the most important stocks in the index to ensure that the fund’s performance is closely correlated with that of the index. They have little turnover of stocks, so once set up they don’t need to be actively managed, keeping fees very low.
There are two types of index funds: exchange-traded funds (ETFs) and mutual funds.
Mutual funds pool the investors’ funds and an investor can usually trade in or out on a daily basis, while exchange traded funds (ETFs) can be bought and sold throughout the trading day, just like stocks.
Expats should bear in mind however that investing in non-US (i.e. foreign) mutual funds is a considerable risk as a US taxpayer, and is normally inadvisable (see the note on PFICs below for more information about this).
Expats can invest in US mutual funds without flirting with the same complex tax and reporting implications, though.
Balance of Core and Satellite
The satellite portion of a core-and-satellite portfolio constitutes the smaller part of the portfolio. Many investment managers work on an 80% core and 20% satellite basis, however the optimal mix ultimately depends on your goals, your time horizon, as well as your risk tolerance.
So if you are looking to build rapid gains, and you are prepared to tolerate a higher risk, you could decide to have up to 40% of your portfolio in satellite investments, which carry a higher risk but also potentially higher rewards.
Remember though that the point of the core is to provide stability and reduce costs and potential losses if the satellite investments perform poorly, so you shouldn’t reduce the size of the core proportion of your portfolio by too much.
Within the satellite portion of your portfolio, you can also reduce risk by ensuring that you have several satellite investments rather than just one.
US tax matters
Don’t forget that investing abroad as a US expat can have US tax reporting implications. The three most common reporting forms to be aware of relating to investments are:
• FBAR filing. As a US expat, if you have over $10,000 in total in any and all foreign financial accounts, including bank and investment accounts, at any time during a year, then you have to file Form 114 to FinCEN to report all of your foreign accounts. Your expat tax accountant can help you with this.
• FATCA filing. Similarly, if the value of your financial assets (including cash and investments) in accounts registered abroad is over $200,000 at the end of the year, or over $300,000 at any time during a year, then you have to file Form 8398 to the IRS along with your federal tax return.
• PFICs. The IRS deems non-US registered mutual funds to be a Passive Foreign Investment Company, or PFIC. Having investments in a PFIC means burdensome US reporting requirements, and there’s often a tax implication, too.
Winding up
Core and Satellite is a tried and tested strategy, however you should always consult with your expat financial advisor to ensure that your investments are set up in a way that will meet your needs and goals.
If you have any questions, don't hesitate to contact us.
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