Asset Classes

The importance of the asset allocation decision when constructing a portfolio cannot be understated. Depending on each investor’s unique circumstance, the types of assets into which they invest, and the portion of funds invested into said assets, can arguably make or break them meeting their financial goals.

It is imperative to construct a portfolio with an asset mix that not only compliments their current financial situation, but also provides the best chance of meeting their goals. Thus, the goal of asset allocation is to make sure the right mix of assets are chosen, in the right proportion, according to the investor’s unique circumstances to provide the best chance of meeting their financial goals.

Asset Classes

So what are asset classes anyway? In general an asset class should have the following characteristics:

  • The assets within the asset class should have similar attributes from both a statistical and descriptive perspective.

  • The assets within one asset class should not be able to be included in another asset class.

  • One asset class should not be highly correlated with another asset class. Correlation refers to the extent to which one asset class moves in comparison with another asset class. This is a very important concept because if asset classes are highly correlated (i.e. move up and down in tandem) then the benefit of diversification by investing in different asset classes is reduced.

  • Asset classes should cover all possible investable assets within that asset class.

  • Asset classes should be liquid. This means that investors are able to buy and sell the various assets within each asset class with ease. Although the degree of liquidity between asset classes varies, the ability to buy and sell with ease should be present.

Fortunately there are three traditional asset classes available to pretty much all types of investors from the get-go.

Equity

Equity is another word for shares of a company. Public companies (those listed on an exchange) issue shares to the public in order to raise capital. When you buy shares of a company you are entitled to a portion of the earnings of that company, assuming the company is profitable. As well as a share of the assets of the company. A company will hold an annual general meeting (AGM) each year where shareholders can vote on various items put forward by the company.

An example of a voting item may be a change in remuneration for directors of the company, and shareholders can indicate their agreement or disagreement through their votes. Generally, one share equals one vote.

Often times a single person (usually the founder of the company) may hold 51% of the shares of the company, in which case whichever way this shareholder votes will be the result. This may sound like a dictatorship to a certain extent, which is a valid concern. However, a board of directors is put into place for every public company whose job is to act in the best interests of shareholders.

These boards of directors are usually made up of some senior management of the company that assist in the day-to-day running of the company, called executive directors. As well as non-executive directors who do not assist in the day-to-day running of the company and may not even have significant experience in the operations of the company.

The general best practice in constructing a board of directors is to have members who have diverse backgrounds and for the chairman of the board and the CEO to be different people. Despite best practice guidelines, the quality of the board of directors between companies will vary.

There are many ways to access equity exposure. You could:

  • Buy shares in a specific company on the open market through an exchange such as the Johannesburg Stock Exchange (JSE).

  • Invest into equity unit trusts (mutual funds) which are managed by an asset manager on behalf of their clients. This allows exposure to a basket of equities and the asset manager’s specific investment style. Since the management is done for you a management fee is usually charged.

  • Invest into exchange traded funds (ETFs). These trade exactly like a share on an exchange and attempt to track a specific index as closely as possible. An example of an index is the JSE Top 40 which tracks the top 40 shares by market capitalization on the JSE. This service is also provided by an asset manager and is usually cheaper than unit trusts because the extent of active management is significantly reduced since these investment vehicles simply track an index. Thus, it is a decent way to access a basket of stocks at a lower fee than unit trusts, although you will not have the benefit of the asset manager possibly changing the construction of the basket of stocks to mitigate adverse market movements.

Fixed Income

Fixed income is the asset class associated with bonds. It is called fixed income because, generally, the investor will have knowledge up front as to the amount and timing of the interest payments the bond issuer makes.

A company can issue a bond in order to raise capital, similar to a share, although the investor that buys a bond from a company will not be able to vote at an AGM. The company that issues the bond will state the interest rate (called the coupon rate) that will be paid to the lender at specific times through the year, as well as the amount of money that will be paid back to the lender once the bond matures.

An important aspect of bonds and equity is that should a company go bankrupt, the investors who lent money to the company through the purchase of bonds will be paid back first before general shareholders. It is also considered a better a sign for a company to raise capital through a bond issue rather than a share issue.

This is because the company must believe they will have sufficient cash flow and earnings to make the obliged interest payments to the bond holders. While issuing new shares does not require a company to make any payment to shareholders in return for the money they invest.

There are many ways to access fixed income exposure: You could:

  • Invest in bond issues through an exchange such as the Johannesburg Stock Exchange. Although it is generally not practical for smaller investors to invest in fixed income this way because a large amount of money, generally R1 million, is the minimum amount to participate.

  • Invest into a unit trust (mutual fund) which are managed by an asset manager on behalf of their clients. This allows exposure to a basket of fixed income securities and the asset managers specific investment style. Since the management is done for you a management fee is charged.

  • Invest into exchange traded funds (ETFs) which trade exactly like a share on an exchange and attempt to track a specific index as closely as possible. An example of a bond index is the JSE All Bond Index which tracks 20 conventional bonds with maturities of more than a year. This service is also provided by an asset manager and is usually cheaper than unit trusts because the extent of active management is significantly reduced since these investments simply track an index. Thus, it is a decent way to access a basket of bonds at a lower fee than unit trusts, although you will not have the benefit of the asset manager possibly changing the construction of the basket of bonds to mitigate adverse market movements.

Note: since the global financial crisis the liquidity of bonds (the ease to buy and sell) has decreased substantially. Investing into either a unit trust or ETF (but specifically a unit trust) helps mitigate the liquidity problem compared to buying a bond directly.

  • Invest into fixed deposits and other money market options provided by banks and asset managers. These generally offer competitive interest rates but can be subject to minimum investment amounts, as well as other rules, which may not be appropriate for all investors.

  • Invest into an SA Retail Savings Bond. These are bite sized bonds which offer interest rates based on the prevailing interest rates in the market, such as the prime rate, or relative to inflation. At a minimum investment of R1 000, these bonds offer decent exposure to government backed assets for the smaller investor.

Alternative Investments

Assets that are not either equity or fixed income are generally referred to as alternative investments. Alternative investments can be an exceptionally good tool within a portfolio because their relationship (defined as correlation) to the equity and fixed income asset classes is often weak, this provides great diversification benefits.

Unlike equity and fixed income, alternative assets are slightly more complicated in that there are a variety of subsets of assets, we will only consider the more commonly known subsets.

Real-estate

Real estate is probably the most familiar type of alternative investment. There are two types of real-estate investment, direct real-estate and indirect real-estate.

Direct real-estate involves buying a fixed property (i.e. the brick and mortar kind) and making income through receiving rent or capital gain. The main issue with direct real-estate is that it is quite illiquid and generally takes a significant amount of time to buy and sell.

Investors often find themselves in a situation in which most of their capital is tied up in direct real-estate and unable to turn it into cash quickly. That being said, a well thought out direct real-estate investment strategy can be incredibly lucrative and rewarding.

Indirect real-estate involves buying shares in a real-estate investment trust, known as a REIT. REITs are companies that specialize in buying properties and then creating cash flows from it usually in the form of receiving rent. The rent that is received from their property portfolio is then distributed between the shareholders, after operating expenses of course.

Thus, although a REIT is considered an alternative investment it has many fixed income characteristics as well as equity characteristics since a REIT is traded on an exchange. Investing in REITs is a great way to have access to a diversified real-estate portfolio while being very liquid due to a REIT trading on an exchange.

Commodities

Commodities are also well known, and like real estate an investor can gain exposure to commodities directly or indirectly. Commodities are generally tangible assets and are essentially the items used in the production and manufacturing process. There are “soft” and “hard” commodities such as corn or coffee and gold or copper respectively.

Investing directly into commodities involves actually buying the commodity, such as a bar of gold and storing it in the safe, or through an exchange traded fund (ETF) that tracks the performance of the commodity. The latter is convenient because it provides the ability to closely follow the performance of the commodity without having to store it yourself. An ETF also arguably provides greater liquidity since the investor does not need to transport the gold to someone to sell, but simply clicks a button.

Investing indirectly into commodities involves buying shares in a company that deals specifically with a commodity, such as a gold miner. You may be asking yourself; “if I buy shares in a company then that’s equity and not an alternative investment.” Well you wouldn’t be wrong, and the shares in the gold miner would indeed be considered an equity investment, but the behavior of the value of the share would act similarly to an investment in the commodity the miner is involved in. I.e. a clothing company’s share behavior is generally very different to a miner’s share behavior. Where share behavior is how the value of the share changes over time.

Next: Return Considerations

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