Tempted to bet big on trendy stocks? Try Core & Explore instead

Do you remember last year when equity markets went on a rollercoaster ride? Besides giving some investors the jitters, the whipsaw market performance also re-ignited the debate around active and passive investing. Proponents of low-cost, passive index-tracking funds are content to ride the ups and downs of markets. Passive investors believe that over the long term, they’ll do as well as or even better than actively managed portfolios. On the other hand, those who favour active investing believe their strategies could deliver better downside risk protection with the potential to yield higher returns, especially during turbulent market periods.

But as analysts point out, portfolio construction isn’t exclusive to one strategy. In fact, many sophisticated wealth management strategies include components of both active and passive investing. One such portfolio construction approach is referred to as “core-and-explore.”

“Core-and-explore works with individuals who largely believe in overall market efficiency and would like to utilize a low-cost passive approach as a key component of their portfolio, along with incorporating a tactical, or active overlay for the remainder,” says Manmeet Bhatia, Senior Vice President of Online Brokerage and Digital Wealth and Chief Wealth Correspondent for Qtrade Investor and VirtualWealth.

How is a core-and-explore portfolio constructed?

The core component refers to the strategic asset allocation of the portfolio. This involves setting and regularly rebalancing the target allocations for various asset classes. Typically, it consists of passive investments that track major market indices. The rationale behind the core portion is to access market returns through low-cost, widely diversified index funds or exchange-traded funds.

If you choose a passive investing vehicle, you gain exposure to a benchmark index. Your investment mirrors the holdings of the index it tracks and essentially offers you the performance achieved by these broad-based indices. It’s an approach that lends itself to a buy-and-hold mentality, which can also help you avoid trying to time the market.

“Markets are unpredictable, and market timing strategies often underperform an approach where individuals stay invested,” Bhatia explains.

But passive investing has its limitations. Critics point to its lack of catering to an investor’s specific needs. Say for example you saw an opportunity for outperformance in the cannabis industry and you wanted to overweight your portfolio in cannabis stocks. The broad-based, capitalization-weighted nature of most passive investing opportunities would limit your ability to gain additional exposure to a specific sector or industry.

That’s when the explore portion, often referred to as a tactical overlay, comes into play. The flexible nature of explore strategies allow you to tailor your portfolio around your preferences including investments to provide additional diversification and potential risk reduction. As a result, they can help you meet or outperform your benchmark.

When choosing active investments, sector-based ETFs, speciality funds or individual stocks are popular options that you can utilize to tilt your portfolio more towards an allocation that matches your investment profile. You may see growth opportunity in certain sectors or regions and would like to overweight these areas.

“Given prevailing or expected market conditions, greater return potential or downside protection may exist in certain geographies, sectors or industries, which react differently to macro-economic factors,” Bhatia adds.

Variations of the core and explore strategy

The core-and-explore approach comes in different flavors. How you choose to allocate the lion’s share of your assets depends on what kind of investor you are. Are you a tactical investor? Do you see opportunity in choppy markets or with individual security price fluctuations? Perhaps you enjoy the freedom of picking promising investments that have the potential to outperform broad market indices. Then, you’ll likely tilt your portfolio towards the explore portion.

But if you want to reduce your risk or exposure to big market swings driven by a specific industry or sector, you’ll likely establish a core asset allocation to anchor your portfolio. A well-diversified core approach, which can track a variety of indices, helps limit the risk of losses from a downturn in any one security, industry sector or asset class.

The effectiveness of core and explore

The core-and-explore approach gives you access to the best of both investment worlds: market-beating strategies in a flexible package that is designed to both limit risks and minimize costs. Blending active and passive investing allows you to establish a well-diversified, cost-effective portfolio.

For many financial analysts, the takeaway from the active versus passive investing debate is that the most practical investment strategy lies in a hybrid solution.

“A core-and-explore approach provides a portfolio with a base exposure to broad-based markets with the opportunity to outperform relative to a benchmark or mitigate volatility for those investors who would like to over-or-underweight a specific portion of their assets,” says Bhatia.

Curious about core and explore? Here are a few tips for getting started.

  • Determine your portfolio asset allocation strategy and decide on your core versus explore portions
  • Remember to rebalance your portfolio regularly: twice a year is a good rule of thumb
  • Rebalance by selling over-allocated assets and buying more of those that are under-represented

Resources:

Krueger, Pam. “Active vs. Passive Investing: What's the Difference?” Investopedia. March 26, 2019. https://www.investopedia.com/news/active-vs-passive-investing/

Smith, Lisa. “A Guide to Core-Satellite Investing.” Investopedia. May 4, 2018.https://www.investopedia.com/articles/financial-theory/08/core-satellite-investing.asp