Asset Classes & Allocation
- Introduction to Asset Class
- Types of Asset Classes
- Products in different asset classes
- Introduction to Asset Allocation
1. Introduction to Asset Classes
Introduction to Asset Class: As per definition, a 'Asset Class' is a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. Asset Class is an often used word in finance, especially investment & portfolio management.
Broadly speaking, there are three main asset classes which are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). However, in addition to the three main asset classes, some investment professionals would add real estate and commodities, and possibly other types of investments, to the asset class mix. Whatever the asset class lineup, each one is expected to reflect different risk and return investment characteristics, and will perform differently in any given market environment.
Why know about different asset classes?
Knowledge and understanding about asset classes is a basic for any person thinks of self as an investor. Though it is not required that one be expert with every asset class, the bare minimum understanding of the nature of main asset classes, the risk profile, returns potential and the way of investing into such asset classes is a humble expectation. In brief, the following are the reasons for knowing about asset classes:
Each asset class is different and there are many points of difference against other asset classes. These differences ultimately impact the investment objectives and performance. The asset classes may differ upon the following things...
Broadly speaking, there are three main asset classes which are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). However, in addition to the three main asset classes, some investment professionals would add real estate and commodities, and possibly other types of investments, to the asset class mix. Whatever the asset class lineup, each one is expected to reflect different risk and return investment characteristics, and will perform differently in any given market environment.
Why know about different asset classes?
Knowledge and understanding about asset classes is a basic for any person thinks of self as an investor. Though it is not required that one be expert with every asset class, the bare minimum understanding of the nature of main asset classes, the risk profile, returns potential and the way of investing into such asset classes is a humble expectation. In brief, the following are the reasons for knowing about asset classes:
- Increased choices for informed decision making
- Better investment management through asset allocation & diversification
- Identifying emerging opportunities & risks for investing
- Being rational, unbiased and confident in investment decisions
Each asset class is different and there are many points of difference against other asset classes. These differences ultimately impact the investment objectives and performance. The asset classes may differ upon the following things...
- Nature and characteristics
- Correlation with other asset classes
- Risk and Returns potential / trade-off
- Ideal investment horizon
- Behaviour w.r.t. markets, interest rates, economic environment, etc.
- Rules, regulations and taxation
2. Types of asset classes
Types of asset classes: There are broadly three basic asset classes considered by most investment experts: (i) Equity securities (ii) Fixed Income or Debt securities and (iii) Cash equivalents. In addition to this, (iv) Real Estate and (v) Commodities are also considered by many as important asset classes given their characteristics and penetration among investors.
Equity:
Long term equity as an asset class has outperformed other asset classes in India as well as in more developed economies. Equity basically enables efficient movement of funds from people having excess to businesses that need it to fund growth and business operations. Equity is a risky asset class and investments should be made for long term. The returns from such investments are in form of capital gains by price appreciation and/or dividend payments by companies.
In India, the equities are largely held directly through stock exchange or indirectly through mutual fund equity schemes. Exposure to equity can also be made through Exchange Traded Funds (ETFs) and Portfolio Management Schemes (PMS) and indirectly through pension schemes / plans that invest in equities. Insurance products, especially Unit Linked Plans (ULIPs) is an another well known route. Equity can also be held in form of stakes or Private Equity in businesses. This option, however, is limited super HNI and corporate investors.
Debt:
Debt is an another asset class which you would be very familiar with. Some of the popular avenues of debt investments are through Fixed Deposits of banks & corporates and bonds issued by governments, RBI and the likes. Small Saving schemes and pension plans by government are another major avenues for investing. Mutual funds schemes are lately becoming popular with retail investors too. The mutual funds offer a wide variety of products to suit every need and risk profile of the customer. It is a relatively less risky asset class and returns are generally in form of interest payments and/or capital gains due to impact of interest rates changes over time.
Commodities:
Commodities may be treated as a distinct asset class since their nature and behaviour differs from the other asset classes. Indians have been traditional investors in 'gold' as a commodity. Other commodities are now finding a favour with investors, albeit slowly. Precious metals like Gold & silver remain the biggest avenue for investment and awareness & exposure to other commodities is very low. The impressive performance of these metals over past few years have made them as asset class hard to be ignored by investors.
The commodity prices tend to follow the cyclical pattern of underlying commodities which is why it is important to understand the demand-supply factors. Needless to say, this is not an asset class for the less informed or the faint hearted, especially for agro-commodities & base metals. Investment is generally for short to medium term and the idea is to profit from price movements or hedge against actual exposure. As an asset class, commodities have been observed to have low correlation with the other asset classes and hence offer excellent potential for portfolio diversification. Investments into Gold specially has also become more convenient & practical for investors with the launch of Gold ETFs and mutual fund schemes.
Real Estate:
Real Estate is a piece of land, including the air above it and the ground below it, and any buildings or structures on it. Real estate can include business and/or residential properties, and are generally sold either by a Realtor or directly by the individual who owns the property (for sale by owner)
Real estate is the original idea of creating assets before the other asset classes become popular among investors. Real estate, especially residential / commercial units, unlike other asset classes, except gold, gives the owners a sense of emotional satisfaction and confidence. Holding physical property has also its own share of social acknowledgment of your financial standing. Land is also treated more than an asset in the largely agrarian economy of India.
From an investor's perspective, the investment in physical real estate has its own share of challenges w.r.t. clear titles, transparency, transaction costs, etc. Emergence of new avenues for investments has, to some extent, made it feasible to get exposure to this asset class with less risks. The returns in this asset class is in form of rental/ lease payments and price appreciation. Real estate are the least liquid of all the asset classes and investment horizon is generally long-term to very long term in nature.
Cash:
As an asset class, cash and cash equivalents is unlike any other asset class. The purpose of holding cash is either for transaction / payment reason or as a precaution for any eventuality or as a buffer for taking advantage of opportunities in other asset classes/ products. Cash is the least productive of all asset classes and delivers little or no returns and over time looses out its real value as well. Cash equivalent holdings are dictated by convenience, comfort and cash habits of people. As an investor, one should try to minimise cash equivalent holdings to an optimum level that strictly meets your needs. Mutual fund liquid funds is considered as the ideal avenue for putting aside money for short durations, giving advantages of superior post-tax returns, high liquidity, very low costs & convenience.
Other asset classes:
Apart of the above major asset classes discussed, there are also some more asset classes considered by few investment experts. You may come across asset classes like currency, derivatives and collectibles. Currency, as an asset class is distinct in nature and it derives its existence because of the exchange rate fluctuations between countries. Currency is something of great interest to governments, banks, multinational corporates having business incomes arising in different countries, and even to individuals where source of income and consumption are in separate countries. Derivatives is an asset class that 'derives' its value from the actual underlying asset class. It is more of a hedging and trading tool and fraught with very high risks, something which is suited only for the experts. Collectibles is an emerging asset class where investments are made in art, antiques & other collectibles. This asset class is now finding more favour with HNI investors who are looking for some diversification & spice in their portfolio.
Using Asset Classes:
Understanding of the asset classes leads us to the question – Whats' next?. The usage of different asset classes are basically two fold. First, the understanding is useful for purpose of diversification to optimise risk-return trade-off. This is because different asset classes perform differently in different markets and also differently from each other. Diversification only works when you combine assets that have opposite or low correlation with each other. The second idea is to decide and follow the 'asset allocation' strategy. The asset allocation strategy has been cited by investment managers & experts as the biggest deciding factor for long term wealth creation. Financial advisors have propagated asset allocation strategies of tactical, dynamic and strategic in nature to their investors keeping in mind their risk profile.
Equity:
Long term equity as an asset class has outperformed other asset classes in India as well as in more developed economies. Equity basically enables efficient movement of funds from people having excess to businesses that need it to fund growth and business operations. Equity is a risky asset class and investments should be made for long term. The returns from such investments are in form of capital gains by price appreciation and/or dividend payments by companies.
In India, the equities are largely held directly through stock exchange or indirectly through mutual fund equity schemes. Exposure to equity can also be made through Exchange Traded Funds (ETFs) and Portfolio Management Schemes (PMS) and indirectly through pension schemes / plans that invest in equities. Insurance products, especially Unit Linked Plans (ULIPs) is an another well known route. Equity can also be held in form of stakes or Private Equity in businesses. This option, however, is limited super HNI and corporate investors.
Debt:
Debt is an another asset class which you would be very familiar with. Some of the popular avenues of debt investments are through Fixed Deposits of banks & corporates and bonds issued by governments, RBI and the likes. Small Saving schemes and pension plans by government are another major avenues for investing. Mutual funds schemes are lately becoming popular with retail investors too. The mutual funds offer a wide variety of products to suit every need and risk profile of the customer. It is a relatively less risky asset class and returns are generally in form of interest payments and/or capital gains due to impact of interest rates changes over time.
Commodities:
Commodities may be treated as a distinct asset class since their nature and behaviour differs from the other asset classes. Indians have been traditional investors in 'gold' as a commodity. Other commodities are now finding a favour with investors, albeit slowly. Precious metals like Gold & silver remain the biggest avenue for investment and awareness & exposure to other commodities is very low. The impressive performance of these metals over past few years have made them as asset class hard to be ignored by investors.
The commodity prices tend to follow the cyclical pattern of underlying commodities which is why it is important to understand the demand-supply factors. Needless to say, this is not an asset class for the less informed or the faint hearted, especially for agro-commodities & base metals. Investment is generally for short to medium term and the idea is to profit from price movements or hedge against actual exposure. As an asset class, commodities have been observed to have low correlation with the other asset classes and hence offer excellent potential for portfolio diversification. Investments into Gold specially has also become more convenient & practical for investors with the launch of Gold ETFs and mutual fund schemes.
Real Estate:
Real Estate is a piece of land, including the air above it and the ground below it, and any buildings or structures on it. Real estate can include business and/or residential properties, and are generally sold either by a Realtor or directly by the individual who owns the property (for sale by owner)
Real estate is the original idea of creating assets before the other asset classes become popular among investors. Real estate, especially residential / commercial units, unlike other asset classes, except gold, gives the owners a sense of emotional satisfaction and confidence. Holding physical property has also its own share of social acknowledgment of your financial standing. Land is also treated more than an asset in the largely agrarian economy of India.
From an investor's perspective, the investment in physical real estate has its own share of challenges w.r.t. clear titles, transparency, transaction costs, etc. Emergence of new avenues for investments has, to some extent, made it feasible to get exposure to this asset class with less risks. The returns in this asset class is in form of rental/ lease payments and price appreciation. Real estate are the least liquid of all the asset classes and investment horizon is generally long-term to very long term in nature.
Cash:
As an asset class, cash and cash equivalents is unlike any other asset class. The purpose of holding cash is either for transaction / payment reason or as a precaution for any eventuality or as a buffer for taking advantage of opportunities in other asset classes/ products. Cash is the least productive of all asset classes and delivers little or no returns and over time looses out its real value as well. Cash equivalent holdings are dictated by convenience, comfort and cash habits of people. As an investor, one should try to minimise cash equivalent holdings to an optimum level that strictly meets your needs. Mutual fund liquid funds is considered as the ideal avenue for putting aside money for short durations, giving advantages of superior post-tax returns, high liquidity, very low costs & convenience.
Other asset classes:
Apart of the above major asset classes discussed, there are also some more asset classes considered by few investment experts. You may come across asset classes like currency, derivatives and collectibles. Currency, as an asset class is distinct in nature and it derives its existence because of the exchange rate fluctuations between countries. Currency is something of great interest to governments, banks, multinational corporates having business incomes arising in different countries, and even to individuals where source of income and consumption are in separate countries. Derivatives is an asset class that 'derives' its value from the actual underlying asset class. It is more of a hedging and trading tool and fraught with very high risks, something which is suited only for the experts. Collectibles is an emerging asset class where investments are made in art, antiques & other collectibles. This asset class is now finding more favour with HNI investors who are looking for some diversification & spice in their portfolio.
Using Asset Classes:
Understanding of the asset classes leads us to the question – Whats' next?. The usage of different asset classes are basically two fold. First, the understanding is useful for purpose of diversification to optimise risk-return trade-off. This is because different asset classes perform differently in different markets and also differently from each other. Diversification only works when you combine assets that have opposite or low correlation with each other. The second idea is to decide and follow the 'asset allocation' strategy. The asset allocation strategy has been cited by investment managers & experts as the biggest deciding factor for long term wealth creation. Financial advisors have propagated asset allocation strategies of tactical, dynamic and strategic in nature to their investors keeping in mind their risk profile.
3. Products in different asset classes
Depending upon the asset class, there can be a multitude of investment / financial products under them. Such products may differ in nature of underlying holdings and/or may be even governed by a distinct set of rules & regulations.
Broadly though, assets can be income-producing, as with fixed-interest earning products, or more speculative in nature, as with stocks and options. A wide variety of investment products exist, including, but not limited to, stocks, options, futures, bonds, mutual funds, certificates of deposit, money market investments, ETFs and annuities. The following is a simplified graphical representation of the different asset classes and products under them in the Indian market.
Broadly though, assets can be income-producing, as with fixed-interest earning products, or more speculative in nature, as with stocks and options. A wide variety of investment products exist, including, but not limited to, stocks, options, futures, bonds, mutual funds, certificates of deposit, money market investments, ETFs and annuities. The following is a simplified graphical representation of the different asset classes and products under them in the Indian market.
4. Introduction to Asset Allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame. In other words, it is an investment strategy that aims to balance risk and reward b apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon.
There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results. Asset allocation is based on the principle that different assets perform differently in different market and economic conditions. A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return.
*Brinson, Singer & BeeBower "Determinants of Portfolio performance: An Update," Financial Analysts Journal, June '91
Asset Allocation Strategies:
There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification: strategic, tactical, and core-satellite.
There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results. Asset allocation is based on the principle that different assets perform differently in different market and economic conditions. A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return.
*Brinson, Singer & BeeBower "Determinants of Portfolio performance: An Update," Financial Analysts Journal, June '91
Asset Allocation Strategies:
There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification: strategic, tactical, and core-satellite.
- Strategic Asset Allocation: is a portfolio strategy that involves periodically re-balancing the portfolio in order to maintain a long-term goal for asset allocation. The primary goal of a strategic asset allocation is to create an asset mix that will provide the optimal balance between expected risk and return for a long-term investment horizon. At the inception of the portfolio, a "base policy mix" is established based on expected returns. Because the value of assets can change given market conditions, the portfolio constantly needs to be re-adjusted to meet the policy.
- Tactical Asset Allocation: is a portfolio strategy in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for gains. In other words, Tactical asset allocation is a dynamic investment strategy that actively adjusts a portfolio's asset allocation. The goal here is to improve the risk-adjusted returns of passive management investing.
- Core-Satellite Asset Allocation: is more or less a hybrid of both the strategic and tactical allocations mentioned above. In this strategy, the portfolio is broken up into two parts – Core & Satellite. Typically, the core part is more long term in nature and a strategy asset allocation policy is likely to be followed. For satellite part, typically a more active and aggressive stance is taken and it is likely that tactical asset allocation is followed that provides flexibility to change assets as per market conditions.