Core and satellite is a model of portolio allocation that breaks the portfolio into two sections: the core, which is invested in traditional stock and bond strategies, and the satellite, which is invested in “alternative” strategies.

Q. What does the phrase “Core & Satellite” refer to?
This is the idea, which is now becoming pretty popular, that average investors should have two parts of their portfolios: a core part, which is exposure to market beta, and a “satellite” part that represents alternatives. Lots of studies have shown that, over the past few decades, these kinds of portfolios have outperformed traditional stock and bond investments.

Q. So, pretty easy to see how to get the core exposure. What about the “satellite”?
A. Well, that’s where this fits in to our Fund of Fund discussion. Most investors would get that “satellite” exposure through some sort of packaged investment covering several strategies at once… a traditional fund of hedge funds, a mutual fund running several alternative strategies, an ETF…or, maybe, through a managed futures account, an idea we’ll talk about in coming shows.

Q. OK, so on Funds of Funds, we started talking yesterday about the diversification benefits they can get you. Here’s a basic question: is there such a thing as too much diversification?
A. It’s a fascinating issue. Several studies have shown some interesting results, especially for Funds of Funds: once the FoF’s investments exceeded about 30 or so subinvestments, performance suffered. And I think the reason for that is that at some point new funds wind up being correlated, not with the market, but with other funds in the portfolio… so adding them actually decreases diversification. For example, two strategic arbitrage funds might act differently from the overall market, but similarly to each other. So more is not always better.

Q. So what makes a great FoF manager?
A. One thing? Diligence. First, of course, to make extremely sure the hedge funds you’re investing in aren’t Madoffs. Second, to monitor their performance against “style drift” to ensure you maintain the diversification you’re trying for.

To do that, FoF need real staff – in the heyday, a lot of individuals jumped into the FoF business without the right infrastructure behind them, and their clients got burned as a result. Frankly, that’s a big reason that FoF haven’t been doing so well over the past couple of years, and why institutions moved to direct investment in the largest, very well known, hedge funds. The industry hurt itself with some inexperienced people jumping in.