The core-satellite investing strategy involves splitting a portfolio into two parts.

The “core” of the portfolio consists of broadly diversified low-cost index funds and is designed to be the foundation around which a portfolio is built. The “satellite” part involves selectively overweighting specifics sectors and regions of the markets in order to generate above-average returns. This requires an active management approach that involves regular oversight of the portfolio in order to take advantage of opportunities. While the core-satellite strategy can be a good, conservative way to try to beat the market, it’s not a fit for everyone.

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One of the main benefits of the core portion of a portfolio is that it keeps shareholder expenses to a minimum. As expense ratios rise, investor returns take a hit. While small differences in expense ratios may seem minor on the surface, they can add up to big money over time. Index funds carry some of the lowest fees in the industry, which means shareholders keep more of their money in their own pockets. Better yet, passively-managed funds benchmarked to a broadly diversified index, such as the S&P 500, provide easy exposure to a large number of companies and industries in one simple product. They make ideal “set it and forget it” options.

The satellite gives investors the opportunity to tilt their portfolio in order to take advantage of current market conditions. For all their benefits, the one drawback of index funds is that their only job is to track an index. It makes no effort to adjust based on what’s going on in the economy or the financial markets. If the market appears significantly overvalued and ripe for a correction, the index fund makes no adjustments. The satellite approach involving active management strategies creates opportunities to react to these events and adjust accordingly to either protect the portfolio or position it to profit. If used to make conservative changes, the satellite can potentially deliver above-average returns without significantly altering the overall portfolio’s risk profile.

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The core-satellite strategy allows investors to create a portfolio more suited to their own tastes. For example, if you’re young and own a stock-heavy portfolio but want to focus on generating dividend income, you could easily add a dividend fund investing in utilities or other high-yield stocks in order to accomplish this. The core-satellite strategy also allows for potentially greater diversification by adding asset classes, such as preferred stocks or commodities, that may not appear in traditional stock or bond indices. A diversified core-satellite strategy could also produce lower overall volatility.

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Unfortunately, active fund management has a long history of failing to beat the markets. While adding satellite investments around the core can potentially improve returns, long-term studies suggest that most active managers lag the markets over time. Index funds have drawn in billions of dollars in net flows because investors are realizing that trying to match an index instead of beating it has proven more successful over time. Actively managed funds also carry higher expense ratios, which can have a detrimental effect on portfolio issues.

Moreover, a core-satellite strategy has the potential for reduced tax efficiency. Actively-managed funds tend to do a fair amount of trading in order to deliver returns. That trading tends to result in higher transaction costs and possible taxable capital gains distributions.

The core-satellite strategy tends to combine the best of both worlds, but it’s not without some minor drawbacks. Adding satellite investments around a diversified low-cost core portfolio can potentially juice returns, but it requires products that keep costs down and are able to successfully time the market with the right security selection. The ability to create a portfolio suited to your personal situation while reducing overall volatility presents an intriguing option for those willing to oversee their portfolio a little more closely.