What investors need to know about major asset classes
Investing can sometimes be complex and investors should always attempt to understand how investible instruments work before putting money in them. One way of making investing more comprehensible is by breaking them down into different groups of similar characteristics. This way, investors can pick and choose the investible groups they are most comfortable with. This should be done with the investor’s risk and return profile in mind, as either some of the investible instruments may not be suitable for the investor but the investor chooses to invest in it or some of the more suitable investible instruments are relatively unheard of or unknown to the investor. One of the ways the investing universe can be grouped or categorised is by asset classes.
Each asset class has its general characteristics in terms of risk and return, though investors should be wary that intra-asset risk and return can also vary greatly. Investors should not treat each asset class as silos but know that these asset classes are part of the larger financial ecosystem with varying correlations, which ultimately should affect how the investor’s portfolio is allocated with the selected asset classes. In other words, allocating the portfolio with the right composition of asset classes is equally as important as trying to pick individual financial instruments within asset classes.
This article will briefly cover the general characteristics of each asset class, how and when to invest in the particular asset class, and selected data on returns. In upcoming issues, we will do a deeper dive into each asset class and analyse other characteristics and nuances of the particular asset class. The asset classes discussed will be the ones that are investible by investors. Some asset classes like private equity will be excluded as it is relatively much harder and inaccessible by the common person on the street and statistics and data are much harder to obtain for investors to properly assess, research and value these asset classes.
The five asset classes that investors should know of are cash, equity, fixed income, real estate and commodities. These asset classes can be ordered based on liquidity, in terms of how easy and convenient it is to convert to cash. Most equities are generally more liquid compared to fixed income. Real estate is usually illiquid unless it is a real estate investment trust (REIT) and commodities have varying liquidity but is usually liquid if traded under exchange-traded funds (ETFs) on an exchange. This is important to note for the investor as investment gains are only useful if realised in cash. If the process to convert it to cash is long and arduous, then it may not be suitable for some investor profiles which require more short-term liquidity.
Before delving into the individual asset classes, investors should be mindful of the macroeconomic factors affecting the asset classes. These include factors such as interest rates and expected movements of interest rates; economic growth and forecast economic growth; inflation and expected inflation; and shocks such as the Covid-19 pandemic or geopolitical events such as the Russia-Ukraine conflict. Depending on how these macroeconomic factors vary from what is expected or forecast, it can greatly affect how investors should allocate their portfolios based on the composition of asset classes. Some asset classes or subsets of asset classes tend to do much better or worse due to their distinct characteristics and varying correlations with other assets classes. For this reason, investors should include this in their framework of crafting their investment portfolio.
Cash
Cash as an asset class covers investible financial instruments like hard cash or fiat money; a deposit or savings account; and money market funds. This asset class is the most liquid as it is the easiest to convert to cash relative to other asset classes. Cash as an investible asset class is generally for investors who require short-term liquidity. As the investment horizon is very short, investment returns from this asset class are usually very low. In terms of risk, it is also relatively lower due to lesser uncertainty over a shorter period, as fewer factors affect the asset class’s returns over a short period.
Money in a savings account is relatively very safe as investors can access funds almost immediately in most cases. Unless a bank run occurs or if the bank goes bust, there is virtually no risk apart from macroeconomic factors like inflation. The returns as an investible instrument, nonetheless, is underwhelming and almost negligible due to its low risk
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Currency such as the Singapore dollar or US dollar is also an investible instrument in the foreign exchange market. The forex market is generally always open, and investors can trade currency pairs when they are actively traded, making it a liquid investment instrument. Currency pairs trading often have varying degrees of risk and is mostly dependent on the amount of leverage the investor has and the currency being traded. Some currencies tend to fluctuate more than others denoting higher risk and a highly leveraged forex currency pair trade can be extremely risky. As such, returns generally also vary for currency trading depending on the risk taken.
Money market funds that invest in shortterm fixed income instruments have very short maturities of a few months. These include government-issued short-term bonds and bills. The lock-in period for these government financial instruments are usually very short, and generally have tax advantages, which reduces the investment risk. Generally, the more liquid an investment instrument is, the expected returns are usually lower as investors do not need to be compensated for undertaking liquidity-related risk and this applies to money market funds as investible instruments with longer lock-in periods usually have higher expected returns due to higher uncertainty and risk.
Cash as an investible asset relative to other asset classes is very liquid and generally have lower expected returns with the lower risk, everything else equal. Chart 1 shows the returns for the Singapore dollar against other major currencies over a three-month, six-month, one-year, three-year and fiveyear period.
Equity
Equity as an asset class covers investible financial instruments such as stocks and exchange-traded funds or ETFs. Equity essentially means ownership in a business or company, and shares of a company represent ownership of the particular company or stock. Equities are relatively liquid but less liquid than cash. Stocks and ETFs can be purchased on the stock exchange, which is usually open during normal working hours. Equities as an investible asset class is suitable for every type of investor as they are relatively easy to convert to cash and cater to investors of varying profiles. The investment horizon for equities can be either really short or very long, hence expected investment returns will vary based on the strategy and amount of risk taken by the investor.
There are various ways to categorise equities but one of the more commonly used ways is through size or market capitalisation. There are usually at least three market cap categorisations for each stock exchange, namely large-caps, mid-caps and small-caps. Large caps tend to be less volatile, cheaper and more liquid when trading hence carrying less risk, everything else being equal. Investors should note that there are other significant factors that affect the price of equities and stocks such as the sector the company is in and other idiosyncratic factors.
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Some stocks tend to be less risky than others. These include mature and stable stocks which are usually companies with a long and established business with relatively low business risk. In contrast, turnaround companies are very high risk as it is usually a case of hit or miss. Other types of stocks include growth stocks, dividend-paying stocks, high-yield stocks and undervalued stocks. The universe of equities as an investible asset is vast and thus caters to both short-term and long-term investors, where investors can utilise both technical analysis and fundamental analysis to pick stocks for their portfolios.
ETFs are unique in the sense that it is a pooled investment instrument that is and can be a basket of any asset class. ETFs can track indices, investment strategies, sectors and industries, commodities and other assets; or a combination of everything. ETFs are usually listed on a stock exchange where they can be bought and sold just like a stock, hence they have relatively good liquidity. ETFs are generally seen as less risky because it has an added component of diversification through other asset classes or stocks, as opposed to investing in a single company.
Equities as an investible asset relative to other asset classes is liquid and have a wide range of expected returns based on the amount of risk taken by the investor. Chart 2 shows the returns of large, mid and smallcap companies listed on the Singapore stock exchange, along with other selected benchmarks over a three-month, one-year, threeyear, five-year and 10-year period.
Fixed income
Fixed income as an asset class covers investible financial instruments like fixed deposits and bonds. Interest or coupons are paid periodically or/and at the end of the tenure (at maturity) based on a fixed interest rate. Fixed income, particularly bonds, are generally less liquid than equity as some bonds are only available to institutional and accredited investors. Though the bond market is larger than the stock market, it is relatively less liquid. Retail investors can only invest in certain types of bonds, due to special requirements and financial constraints. Hence, the risk is relatively lower compared to stocks as the variety of stocks to choose from is much more and mostly unconstrained.
Fixed income is also generally less risky than equity as an investible asset class as the biggest risk is whether the issuer can settle coupon or interest payments and the final payment. In addition, the payment is usually fixed, excluding macroeconomic factors such as interest rates and inflation. Equities, on the other hand, fluctuate greatly, resulting in unknown returns to the investor. Even if the worst-case scenario happens where the company or issuer goes bust, usually the bondholders are paid first with whatever the company can pay out before winding up.
There are many ways to categorise bonds but one of the more commonly used ways is by the quality of the bond, represented by its rating by credit rating agencies such as Moody’s, Fitch and Standard and Poor’s. There are two main types, which are investment-grade bonds and high-yield bonds. Relative to high-yield bonds, which are also known as junk bonds, investment-grade bonds are of usually higher quality as it is less risky. Being less risky, investment-grade bonds have lower volatility, lower yields and lower expected returns. High-yield bonds have greater credit or default risk and are better for bond investors with a higher risk capacity and appetite. Usually, government bonds are investment-grade while corporate bonds have a wider range of credit ratings.
Fixed deposit accounts generally pay higher interest compared to a savings account. The fixed interest payments require investors to lock up their money in the account for a certain period of time and the longer the duration, the higher the amount of return. However, it is not as liquid as stocks where investors can buy and sell freely, as investors have to lock up their money. If the investor however chooses to withdraw their money from their fixed deposit account, they may have to forfeit the interest payments and any returns on that account; hence is not suitable for investors with very shortterm liquidity needs.
Fixed income as an investible asset relative to cash and equities is less liquid, and have a much lower risk compared to equities as the payments and returns are fixed, as the name suggests, everything else equal. Chart 3 shows the yield curve chart for a oneyear, two-year, five-year, 10-year and 30-year Singapore Government Security (SGS) bond over three years.
Real estate
Real estate as an asset class covers investible financial instruments like property and real estate investment trusts (REITs). Property investment is essentially buying a property and selling it for a much higher value for positive investment returns. The common strategy for property investing is where the investor buys and holds a property for a short period and then flips or sells it for a profit. The amount of return or profit depends on a variety of factors but factors such as an appreciating property market due to a multitude of factors or renovating the property can positively contribute to the value of the property. The other strategy is to rent out the purchased properties instead of selling them, which provides a steady and stable source of return, usually.
The real estate market is very illiquid as it takes a very long time to buy and sell a property or to find sellers and buyers, relative to the stock and bond market. Investors also need to commit a significant amount of capital to purchase a property, which implies that it is not suitable for investors who have short and consistent liquidity requirements. Investors also need to be wary of taxation policies for short-term property investment gains, which can affect the return on this asset class. Rather, real estate as an asset has a low correlation to other assets, which implies that it can be a good tool to diversify the investor’s investment portfolio. Additionally, it is a good hedging tool against inflation as its value has a positive relationship with economic growth.
Conversely, REITs is very liquid as it listed on exchanges, similar to stocks and ETFs. REITs, simply put, is an investible company that owns, and usually operates income-producing real estate. REITs are relatively lowrisk compared to stocks as they are usually mandated to pay almost all taxable profits to their unitholders or individual investors. These dividends or distributions provide the investor with a stable stream of income, and usually have tax advantages in most jurisdictions. It also has the added element of capital or price appreciation for investors. Some examples of the type of REITs include retail, commercial, healthcare, hospitality and data centre REITs.
Real estate as an investible asset relative to cash, equities and fixed income is very illiquid unless it is a REIT. Property generally has lower risk compared to equities in terms of price volatility, and REITs are also comparatively less risky as it is less volatile and most of their returns derives from distributions or dividends, usually. Chart 4 shows the performance of Singapore REITs or S-REITs indices over five years.
Commodities
Commodities as an asset class covers investible financial instruments like agricultural products such as soybean or energy products such as oil and metals such as gold. Investors can directly buy the actual commodity and sell it but for the common investor on the street, it is not pragmatic. Therefore, other than buying shares in companies that produce commodities as their primary business, investors can buy commodity ETFs or futures contracts for the given commodity.
Commodity futures trading involves the investor buying or selling the commodity at a specific time in the future at an agreed price. Investors can access futures trading through brokerage firms that offer these services, though investors must be wary that physical delivery can be part of the future contracts’ investment process. Usually, this is not the case for individual retail investors who are merely seeking to profit from the price movements for the commodities.
Commodities can be very volatile depending on the amount of leverage utilised by the investor. Similar to currency trading, margins and leverage are commonly used by futures commodities traders and investors. The higher the leverage, the higher the risk and potential or expected returns. In terms of risk, due to its lower correlation with stocks and bonds, commodities can be a good diversifying tool for an investor’s investment portfolio.
Generally, commodities as an investible asset class can have higher volatility than stocks and bonds as the demand and supply characteristics frequently change for some commodity types. Gold and oil are examples of commodities that retail investors commonly trade and invest in and are offered by most futures trading brokers.
Commodities as an investible asset class is relatively liquid compared to other asset classes such as ETFs or futures. Investment risk depends on the type of commodity, as the demand and supply dynamics for each commodity type can vary, which primarily drives the prices of commodities. Chart 5 shows the performance of oil, gold and soybean futures over five years.
For more thoughts on the nuances and quirks of each asset class, and how investors can use them for their own advantage, watch this space.
