Asset classes

For purposes of investment, an asset is any item of economic value owned by an individual or corporation.  The fundamental assets of our economy –natural resources, skilled labor, and infrastructure– are used to produce a wide variety of goods and services 1.  Included among all goods and services are the financial assets that can be converted to cash in marketplaces where trading generates profits and losses.  An asset class is a group of financial assets that have the same legal structure and share the same market exposure 2.  Table 3 lists the asset classes of greatest interest to individual investors.

Table 3.  Asset classes for individual investors.

Asset class Global capital Risk Return Liquidity
Bonds 45 Low Low High
Equities (Stocks) 28 High High High
Real estate 6 Low High Low
Cash equivalents 4 Low Low High
Derivatives 650 High High High
Commodities High Volatile High
Gold Medium Low High
Infrastructure Medium Medium Low
Art & Collectibles Medium Medium Low

 Legend:  Asset class is an investment category that can be characterized by market region, business sector, and other useful criteria.  Global capital  is the estimated year-end total amounts of capital invested in asset classes during 2004-2008, except that derivatives were valued as the total theoretical principal value during 2010 3,4,5.  Each number represents trillions of U.S. dollars.  The Risk of an investment loss and likelihood of an investment Return are use to facilitate decisions about allocating assets to an investment portfolio.  Liquidity refers to the ease of trading financial assets.  Assets that are easily convertible to cash have high liquidity 2.

Bonds

Bonds are debts that require the borrower (issuer) to pay a lender (investor) the amount borrowed (principal) plus interest over a specified time (maturity).  Interest is the relevant source of future cash flow to investors.  Bonds offer businesses and agencies an alternate source of borrowed capital in addition to bank loans in the currency market.  Central government bonds typically have the highest credit ratings in their countries.

  • Credit ratings are used to evaluate the risk of borrower default on timely payments of interest and principal.  Bond default is any missed or delayed payment, or the exchange into a new package of securities.  Riskier bonds (i.e., junk bonds) generally have higher yields that the safer investment-grade bonds.
  • Bond yield (ratio of interest/price) serves as an index of investment return.
  • Bond liquidity is variable and decreases with the length of maturity.

Classes of bonds that qualify for inclusion in a bond market index are government, securitized, corporate, high-yield, and emerging-market debt.  Interest rates on bonds tend to increase with inflation because fixed income investors require a real return 5.

Equities

Equities are shares of ownership in a company that provide rights to corporate income and capital after the settlement of all obligations to creditors.  Shareholders typically have voting rights in matters of corporate governance.  The relevant source of future cash flow is characteristically linked to corporate earnings and dividends.  The long-term return of equities –~7% in mature markets– is considered to be high and tends to provide protection against inflation.  In contrast, the short-term return on equity tends to decline during periods of high inflation 5, 6.

Private equity is a group of unlisted equities that are traded in private markets, rendering them illiquid (and opaque) by comparison to the ease of trading in public markets 5.

The global capital markets can be divided into developed markets and emerging markets 4.  In 2010, emerging markets comprised 16% of the global equity market capitalization.  Emerging market equities have characteristically higher risk and higher returns than developed markets 5.

Real estate

Real estate investments provide ownership of physical assets (i.e., commercial and residential properties) and rights to future income stream from the property & land.  The best way to view real estate is as a physical asset in which the relevant source of future cash flow is cash yield (e.g., rent).  Physical assets deteriorate unless maintained by costly capital expenditures.  The appraisal value of a property is its current and future income stream.  Various real estate assets provide a spectrum of risks and returns to investors.  Investors can enter the real estate market through private or public markets.  Private markets promote unlisted investments in property and funds.  Private real-estate investments are valued at net asset value of the underlying property.  They tend to be high cost, high return, and illiquid enterprises.  The opposite tendencies apply to real estate investments in public markets.  Public markets list shares of real estate companies and real estate investment trusts (REITs).   The investments are valued at public auction prices.  Assuming that most of the return from real estate investment is derived from stable long-term income, real estate investments are considered low-risk, high-return.  Real estate is an illiquid investment due to pricing discrepancies and transaction time 5, 6.

Derivatives

Derivatives are contracts between a buyer and seller that are based on the price movements of underlying assets.  In 2010, the underlying assets were distributed among interest rates (79%), currencies (8%), credit default swaps (4.6%), equities (2%), commodities (0.4%), and otherwise unallocated (6%).  The biggest demand for derivatives arose from the risk management of portfolios by financial institutions.  For example, Banks use interest rate derivatives to manage potential mismatches between assets and liabilities.

“Futures” are contracts to buy (‘long position’) or sell (‘short position’) an asset for a fixed price at a future date.  Price movements of futures mimic those of the underlying assets 5.  “Swaps” are contracts to exchange payments based on different assets.  For example, the interest rate swap requires an exchange between the cash amount for a fixed interest rate and the cash amount for a floating interest rate.  The contract is written to begin with equal fixed and floating interest rates.  The sides of the swap are called legs; the fixed leg and the floating leg.  “Options” are rights, not obligations, to buy or sell an underlying asset at a fixed price (‘strike’) up to the time of maturity.  The buyer of an option pays a premium for the right to buy or sell.  The right to buy is known as a “call” and the “long position”.  The right to sell is known as a “put” and the “short position”.   The right, not the obligation, to trade distinguishes the option contract from the future and swap contracts 5.

Commodities/Gold

Commodities are materials (e.g., precious metals, base metals, foods, energy) that produce no direct income.  They have no obvious claim to an underlying cash flow but are viewed as liquid assets which provide diversification and a hedge against inflation.  The volatiles prices are driven by perceived differences between supply and demand 5.

Gold is a precious metal held by central banks and used interchangeably with money.  Gold historically provides a long-term hedge against inflation, but this may not continue.  Gold is highly liquid and used as an “insurance policy” 5.

Infrastructure

Infrastructure is a class of physical assets (e.g., toll roads, healthcare facilities) that require the management of contracts and capital reinvestment.  They are permanent assets needed for the orderly operation of an economy.  The underlying cash flow from infrastructure is expected to be stable and sufficient to hedge against inflation.  New assets are expected to generate capital growth and established utilities are expected to generate dividend yield 5.

Art and collectibles

Physical assets such as art and wine don’t have an underlying cash flow, but may increase in value over time.  They may be expensive to store and maintain.  Investments in art are considered to be high risk (due to low returns in a down market), costly, and illiquid 5.

Investments excluded from asset classes

Hedge funds and related funds are able to use leverage to gain investment exposure to currencies and asset classes.  Currency is not considered an asset class since it is a basic property of all financial assets.  However, the forward currency market enables the capture of excess currency returns 5.

The allocation of asset classes to an investment portfolio is an important determinant of investment returns that deserves further discussion.

Copyright © 2012 Douglas R. Knight

References

1.           “Free exchange.  The real wealth of nations”.  The Economist, June 30, 2012.

2.           Asset class.  Dictionary of Financial Terms. Copyright © 2008, Lightbulb Press, Inc.  http://financial-dictionary.thefreedictionary.com/Asset+Class

3.           Global Investable Capital 2004 ppt.  Frontier Asset Allocation Slides.  SunGard Online Investment Systems, Copyright 1997-2005 SunGard Expert Solutions.

4.           Asset Allocation Part 1: What It Is and Why You Need It, by JIM FINK on MAY 6, 2010 in STOCKS TO WATCH , Copyright © 2012 Investing Daily, A Division of Capitol Information Group, Inc. http://www.investingdaily.com/10929/asset-allocation-part-1-what-it-is-and-why-you-need-it .

5.           John Nestor, Sion Cole, David Buckle, et al.  Charity Compendium 2011. A long-term perspective on charity fund investment.  UBS Wealth Management.  © UBS 2011. All rights reserved. October 2011.

6.           Buttonwood: The great divide. Why American house prices have corrected more than those in Europe.  The Economist. Apr 28th 2012, Copyright © The Economist Newspaper Limited 2012.  www.economist.com/node/21553459/print

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