Core and explore is often seen as the opposites-attract couple of investment strategies: play it safe in the core with index products; and use the exploratory or satellite component—between 10% and 20% of the portfolio—to rake in outsized returns.
While the explore bucket will typically be riskier than the core, it’s not a free-for-all, says Chris McHaney, a portfolio manager at BMO Asset Management in Toronto. “A higher level of risk in the satellite is fine, so long as the portfolio as a whole matches the investor’s risk tolerance.”
He suggests explore be used for thematic, shorter-term tactical bets. If you think real estate will outperform in the next two years, use part or all of the explore bucket to gain this exposure. Then, when this play runs its course, reallocate.
McHaney defines the investment objective and price target upfront. Say suburban Chicago’s real estate market hasn’t recovered at the same pace as other parts of the country and you expect it’ll catch up.
The undervaluation means there’s a buy opportunity; the discrepancy also implies a sell target once prices start to climb. “You can either trim close to the valuation target or wait until you reach it and sell the whole position,” he adds—depends on whether you have other strategies lined up. “If nothing catches your eye, or there’s nothing else in the explore bucket, consider trimming. Otherwise, sell off the existing position and move into other [strategies].” Ideally, there would be multiple strategies. “But if you have only one it shouldn’t be high-risk,” McHaney says.
The core should be “be built around buy-and-hold investments,” he adds. “Review it once a year for suitability and make changes in response to any major market moves. But it should otherwise be left alone.”
For a client in the accumulation phase with a 10-year time horizon, the core will typically have 60% equities, 40% bonds. “On the equity side, there should be a good chunk in U.S. stocks to go along with Canadian exposure. Clients should also include Europe or Asia, tilting one way or the other depending on the long-term outlook,” McHaney says.
On the bond side, clients with higher risk tolerance should have corporate and high-yield exposure. Tilt those who can’t handle risk to lower duration, he adds.
Risk management in the explore bucket is especially important when it includes private placements, says Garnet Anderson, vice president and portfolio manager at Tacita Capital.
He avoids single-company deals and assesses offerings against a clear historical benchmark. “Say you want to buy a diversified 20-pack of small U.S. companies. Even though it’s a private pool, you can still use an index like the Russell 2000 for guidance on what the drawdown picture looks like. If you buy only one company, the Russell 2000 won’t help.”
Anderson adds it can take five to 10 years for returns to gestate.
Another issue: Using explore to invest in private equity pools may mean cash calls. “The client […] has to be able to fund those calls,” he says. “That money will likely come out of the core, so it typically needs a higher cash component.” Anderson’s preferred core strategies put a premium on patience. Depending on the client, he uses low-volatility, value, small-cap and momentum strategies in his equity allocations.
“These approaches typically bear fruit long-term and clients may face less-than-ideal performance for years. If they’re impatient it’ll be difficult to see these strategies through.”
He also likes infrastructure, utilities and REITs. “Their volatility isn’t as low as bonds but it’s typically not as high as pure equity,” he says.
And a REIT’s cash distribution is comforting for investors. “When clients know a future purchase needs to be funded with a stock sale, they worry the market will fall at the worst possible time,” Anderson explains. “REIT distributions, which are far less volatile than daily market prices, provide greater certainty around funding requirements.”
Exploring the core
If a portfolio were two-thirds invested in alternative strategies, you might think the client is a 30-year-old with $30 million.
Not so, says Craig Machel, investment advisor at Macquarie Private Wealth. “This is the mix I use for a client who doesn’t want to lose more than 5%. He has $1 million to invest, but more tied up in his business. He understands as a business owner he already has plenty of risk, so with the capital he’s set aside he wants to stay conservative.”
He says it’s a misconception that alternatives are always for aggressive investors.
To that end, he modifies the core-and-explore approach into a three-bucket model, with each typically holding one-third of the portfolio’s weight.
The approach can be tweaked to suit varying levels of risk, but it’s geared primarily towards conservative clients with investable assets of at least $500,000.
Bucket 1: Equity
This bucket includes conventional, long-only equity exposure focused on dividend-paying blue-chip stocks.
Machel notes some clients are so conservative that even these stocks seem too risky. “From a financial point of view these clients can tolerate the risk, but it’s psychologically difficult, so we use only the second and third buckets.”
Bucket 2: Private real estate yield
This bucket is “all about collecting reliable yield,” says Machel. There are two components. The first is income through mortgage investment corporations (see “Don’t overlook mortgage investing”). The second is yield drawn from residential apartment buildings and grocer-anchored malls (see “Commercial property offers returns”). “Since these are mostly private strategies, you eliminate the ups and downs of the market,” he explains.
Bucket 3: Enhanced equity and income
This third bucket is the lynchpin of Machel’s strategy for dealing with tighter correlations. It involves a range of tools including leverage, derivatives and shorting. “They can be used in a high-risk chase for outsized returns, but in my hands they’re actually risk management tools in a conservative strategy.” (See “Alternative strategies require due diligence.”)
His use of shorting illustrates the point. He’ll have one basket of stocks across multiple sectors, all with strong outlooks. Another will have the opposite: poorly managed, expensive companies with terrible outlooks. “We’re long on the first basket and short on the second. When the market falls, our short positions both brace the fall and add value,” Machel explains.
He notes clients won’t capture as much of a bull market as they would with more conventional strategies. “Since we’re always hedged, we miss a piece of the upswing. But we’re fine with that because we know that when the market turns sour, we’re much safer.”
The SG U.S. Market Neutral Fund, offered in Canada through Arrow Capital Management, employs this strategy and is one of Machel’s preferred offerings.
It focuses on small- and mid-cap U.S. equities. “Analysts don’t cover this space closely so there’s more opportunity to gain an information edge,” Machel says.
Common sectors are technology, health care, defense and infrastructure. The fund focuses on short-term buying and selling based on quarterly earnings announcements. “The fund’s team takes a position on a company’s outlook four to six weeks ahead of its announcement; if they expect the share price to go up after the news, they go long; if they think it’ll go down, they buy short,” he explains.
There’s another element to this strategy. Say there’s a small microchip manufacturing firm the team would normally go long on, but the sector behemoth—a firm like Intel—plans its earnings announcement just prior to the little guy’s. A sour report from an Intel could derail what would have been a positive report from the smaller firm.
Options can manage this risk. For instance, SG would buy an option on a microchip company “to protect their capital in the event the larger firm’s announcement negatively affected the whole sector,” Machel explains.