Asset Classification
An asset class is a group of comparable financial instruments that have some economic similarities. Traditionally, there has been little correlation or, in some cases, negative correlations between different asset classes. Financial securities can be categorized into different asset classes based on the legal terms of the financial instrument, as well as the risks inherent to the financial instrument.
In general, equities come with the risk of total loss and the potential for unlimited gains. More conservative fixed income vehicles, meanwhile, tend to offer consistent but limited gains along with the potential to recover, in the event of bankruptcy, some or all of the principal. Distinctions between the asset classes, however, are not as simple as it may seem.
Many equity vehicles bear the hallmarks of fixed income (such as AAA-rated dividend-yielding stocks), while many fixed income securities carry similar risk as equity (such as high-yield bonds). To make matters even more complicated, there are financial instruments that can alternate between the asset classes, changing from stock to bond and vice versa (for example warrants and convertible debentures). The important thing to remember is that assets should not be diversified on the basis of simple labels, but also by the risks and correlations associated with the investment. Traditional asset classes can be divided into three categories: fixed income, equity and cash.
Fixed Income
Fixed income is a broad asset class that includes government bonds, municipal bonds, corporate bonds and asset-backed securities (like mortgage-backed bonds). They are called fixed income because they provide returns in the form of fixed periodic payments, referred to as the coupon, over a defined period of time known as the period of maturity. Fixed income is characterized by a lower rate of return because it tends to be less risky than equities.
Fixed income returns (or losses) include capital gains and the income that the securities yield. The capital gain or loss refers to the change in the price of the security. Income is the interest paid on the bond. If the fixed income security is held until maturity, the principal is returned and the security expires.
Most of the risk in fixed income comes due to price swings in market demand. Ironically, this is known as interest-rate risk, even though it’s the price of the security that changes (not the coupon). Typically, bond prices rise when stock prices fall because during periods of weak risk sentiment, investors move into safer vehicles, generating demand for bonds. That being said, bond prices can also fall during periods of extremely weak sentiment if investors are selling out of financial markets altogether and moving into cash. Interest rates, therefore, are a reflection of the market’s expectations for the economy.
Because longer-term bonds are speculating farther into the future — sometimes as far as 30 years — the price of these bonds swing much more than shorter-term bonds. A portfolio with a longer average maturity is said to have increased duration, a term that describes how much interest-rate risk a portfolio carries. You can think of duration in the same way a stock has a beta.
When central banks raise their policy rate, it acts as a brake on the economy, with compounding effects that impact longer-term economic prospects more than short-term prospects. Portfolios with high duration, therefore, are more affected than those with low duration. The other type of risk that comes with fixed income is called “credit risk,” which is simply the risk that the underlying debt issuer (whether a corporation or a government) will default on its legal obligations. This can happen as a result of a downturn in the business or
a misrepresentation by management, but it can also happen as a result of weak market sentiment.
Debt covenants between creditors and issuers usually require that corporations stay above a certain level of market capitalization. If weak market sentiment drags a company’s valuation below that threshold, creditors can force a bankruptcy even though nothing material has changed about the business. Investors rely on rating agencies such as Standard & Poor’s (S&P), Moody’s and Fitch to determine the likelihood of default by an issuer, with ratings ranging from AAA to D. Debt rated above BBB (or Baa3 for Moody’s) is classified as investment-grade; below this level, bonds are considered high-yield or sometimes called junk bonds.
The yield for a 10-year corporate bond is typically higher than a 10-year government bond because a corporate bond has higher credit risk. Or, to put it another way, a 10-year corporate bond is cheaper than a 10-year government bond because corporations have a greater chance of defaulting than government. This is due to the fact governments have a substantial tax base they can use to repay loans.
Equities
Equities comprise investments in common stock, preferred stock, income trusts, etc. This class is characterized by high returns and high risk. The potential returns on this asset class are the largest of the three traditional asset classes and usually come from an increase in the share price or from dividends.
Because equity investments come with an ownership stake in the underlying business, there’s little in the way of legal recourse should the business go under. Company specific risks vary by sector and depend on the strength and operations of the firm. Aside from company specific risk, equity investments also carry market risk. While the company may be stable from an operating perspective, weak market sentiment may drag down the share price.
This risk can be mitigated by simply waiting out the cyclical downturn. But for investors who need to withdraw funds at the bottom of the market cycle, this risk can be significant. Unlike fixed income, equity does not provide guarantees; investor returns depend on the success or failure of private companies in a competitive market. Equities can also be divided into numerous sub-classes. Stocks can be classified by size, for instance, with
small-cap stocks providing more potential for growth than large-caps, but with higher volatility.
Stocks can also be classified by their price multiple (share price divided by earnings per share), with value stocks usually generating higher dividend yields, and growth stocks attracting higher prices due to their superior growth profile.
Finally, equities can be divided by the regions in which they operate including domestic, developed or emerging market. Depending on the region, these stocks may offer potential for growth and diversification; however, they may also be subject to currency risk, which is the risk that a devaluation in the investment currency will, all else being equal, result in a negative return measured by the investor’s reference currency.
Cash and Equivalents
Cash and equivalents include gold, commercial paper, cash on hand, bank deposits, money market funds, etc. Cash and its equivalents usually come with great liquidity and little volatility, but they also are likely to provide negative long term returns. In fact, cash itself can only produce a positive return in a theoretical deflationary economy. The advantage of this asset class is liquidity; it can be spent quickly and easily.
Essential Ingredients
Each asset class is like an ingredient that plays a unique role in the portfolio, providing the potential for growth, income, relative stability, liquidity or inflation protection. For example, stocks can offer growth or dividend income; cash can be used as defensive assets offering
liquidity and stability; bonds provide a steady stream of income, while inflation-protected bonds can minimize the corrosive impact of inflation.
Each asset class reflects different risk and return investment characteristics and performs differently in any given market environment. A portfolio containing different asset classes tends to have lower risk and greater diversification because of the lower correlation among asset classes. For instance, when the stock market fall, bonds tend to rise as investors seek safer havens for their money, and bonds tend to retreat as stocks rise, since bonds offer much lower returns. The above is by no means an exhaustive list. There are a bunch of asset classes we did not touch on such as commodities, currencies, and alternative assets. For now, we’ve presented the basics and hope you learned a little bit about each asset class.
Now that you have a solid understanding of the three primary asset classes head over to our next less on Asset Allocation.
Frequently Asked Questions
Q: What is an asset class?
A: An asset class is a group of assets defined by their shared risk profiles and legal obligations. These differentiations have resulted in low or negative performance correlation, allowing for diversification within a portfolio.
Q: What characterizes the risk and return profile for fixed income vehicles?
A: Fixed income generally has lower returns and risk compared to equity. Their returns consist of capital gain and current income. Risks generally include interest-rate risk (measured by duration) and credit risk (measured by credit rating).
Q: What characterizes the risk and return profile for equity vehicles?
A: Equity returns consist of capital gain and dividends. Equities are sensitive to market risk and company specific risks. Equities can be further divided by size, growth profile and region.
Q: Why is it important to understand each asset class and their characteristics?
A: Each asset class is expected to reflect different risk and return characteristics and perform differently in any given market environment. A portfolio containing different asset classes tends to have lower risks because of the lower correlation among asset classes, which provides the portfolio with certain diversification benefits.