Interested in getting a basic understanding of asset classes?

In this article equily co-founder, Helen Lawton breaks down asset classes, and how they can be used to create a diversified portfolio.

“Asset Class” is the name for the general types of investible assets, mainly equities, bonds, alternatives (such as real estate and gold) and cash.

Asset Class 1: Equities

Companies raise capital in order to carry out their activities. They can do this in two ways, by issuing new share capital (equity) or by issuing loans (bonds). Investors who hold bonds are creditors of the company – the company owes them a debt. Investors who own shares (equity) in a company are its owners. An investor may only own a few shares in a company that has issued thousands or even millions of shares, but the investor still owns a small part of that company.

Previously-issued (i.e. second-hand) company shares are traded by investors on stock exchanges around the world. Companies usually (but not always) list their shares on stock exchanges in the country where they are headquartered and carry out the majority of their business. Owning a share in a company (an equity) gives you a slice of any future earnings and realisations from the productive activities of that company.

As of 2019, there were just over 43,000 publicly listed companies globally:
https://www.statista.com/statistics/1259025/global-listed-companies/

Explainer: Index Providers (MSCI and FTSE Russell)

All publicly listed companies – equities – are classified by country and by sector. The relevant country is the location where the company has its main stock market listing and usually its headquarters. There are two main global index providers, the MSCI and FTSE Russell, who provide (among other things) equity, fixed income (bonds), and real estate indices.

Most passive index tracking funds are based on indices from either the MSCI or the FTSE Russell. There are currently 47 countries in the MSCI All Country World Index, of which 23 are classified as developed and 24 as emerging (https://www.msci.com/our-solutions/indexes/acwi). Developed and emerging markets are also grouped into three world regions – the Americas, Europe the Middle East and Africa (EMEA), and Asia Pacific (APAC). Be aware that South Korea is classified as an Emerging Market by the MSCI, but as a Developed Country by the FTSE Russell, as this can lead to “double counting” of South Korea in a portfolio if you mix and match FTSE Russell and MSCI index funds.

As well as a country and regional classification, every listed company in the world has an industry classification. The MSCI has 11 industry sectors, these are: Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Healthcare, Financials, Information Technology, Communication Services, Utilities and Real Estate. The FTSE All-World Index has similar country and industry sector classification systems.

As of 31st October 2022, the MSCI’s All Country World Investible Market Index shows that the US accounts for 62.08% of the world’s stock market (in USD, by market capitalisation) and the UK just 3.79%. The Information Technology sector is the largest sector globally (in USD, by market capitalisation) at 19.78%, and Utilities the smallest sector, at 3.04%: https://www.msci.com/documents/10199/b93d88ef-632f-4bdb-9069-d7c5aecd9d6d

Asset Class 2: Bonds (Fixed Income)

A bond is a loan. Companies and governments issue bonds. By buying a bond, an investor is lending money to the issuer of that bond, for a set time period. In return, the bond issuer pays the bond holder interest (called the “coupon”) as a fixed percentage of the face value of the bond. At the end of the bond’s lifetime – when it matures – the bond issuer repays the initial investment (known as the “principal”) to the bond holder.

The maturity date and coupon are specified in the bond when it is issued – usually in its name. Bonds are usually issued at par, meaning their face value.

An investor can buy a newly-issued bond and hold it to maturity. Or an investor can trade previously issued bonds with other investors.

Just like equities, bond prices rise and fall due to supply and demand, between the time they are newly issued, and the time they mature. A bond’s yield is its coupon relative to its trading price, thus a bond’s yield varies according to its trading price. If the trading price of a bond rises, its yield falls, and if the trading price of a bond falls, its yield rises.

The two most important features of a bond are the credit quality of the issuer and its maturity.

Credit quality: A bond’s trading price may fall if investors believe there is an increased risk of its issuer defaulting (this is when an issuer fails to repay the debt when the bond matures). A bond’s trading price may rise if investors view that bond as a safe haven because other investment assets are suddenly perceived as more risky.

Credit ratings on bonds are predominantly provided by three global credit ratings agencies – Moody’s Investor Services, Standard & Poor’s (S&P) and Fitch IBCA. Government credit ratings are known as sovereign ratings. The highest credit quality (i.e. safest) bonds are those issued by developed governments in their own domestic currency.

The next safest bonds are quasi-government bonds of developed nations (bonds issued by other public sector entities like cities, municipalities and government lending agencies). The next safest are corporate bonds issued by companies in developed nations. Like sovereign (i.e. government) credit ratings, corporate bonds are credit-rated on a scale from investment grade (blue chip companies) to high yield (also known as speculative or junk bonds). The majority of the global bond market is comprised of investment grade government and corporate bonds issued by developed nations.

Maturity: Bond prices also change in response to changes in interest rates. An increase in interest rates makes an existing bond (and its now below-market interest rate) worth less, while a fall in interest rates makes the bond worth more. Bonds with longer maturities have higher yields because it gets progressively riskier to lend further out into the future, bond-holders are compensated for this additional risk. Bonds with long maturities are also more sensitive to interest rates (the sensitivity of a bond to interest rate changes is known as “duration”). The longer the maturity, the higher the bond’s duration, thus longer maturity bonds are riskier because the effect of interest rate changes is magnified. If a bond has a duration of 10, and interest rates rise by 1%, then its price will fall by 10% since higher interest rates mean lower bond prices.

There are many types of bonds, the main ones an investor may encounter are:

Agency Bond: A bond issued by a quasi-government agency. They usually have an implicit or explicit government guarantee but tend to be slightly riskier than government bonds issued by central or local government.

Convertible Bond: A bond which is convertible, under specific conditions, into a certain number of the issuing company’s shares.

Covered Bond: A bond backed by a specific cash flow, e.g. mortgages or credit card payments.

Corporate Bond: A bond issued by a company. Usually refers to bonds issued by companies with investment grade ratings.

Emerging Market Bond: Both companies and governments within emerging market nations issue bonds. Some emerging market bonds have an investment-grade credit ratings while others are high yield. Emerging market bonds are issued in either the local domestic currency, or in a stable foreign currency (such as the US dollar or euros) where there is more demand from international investors. In a crisis, the issuer of a bond issued in a stable foreign currency may struggle to find the foreign currency reserves to meet their debt obligations.

Emerging market bonds have a higher correlation with equities, and during a market crisis are more likely to behave like equities and less like safer bonds (such as bonds issued by the governments of developed economies). Emerging market bonds, both corporate and government, account for only a small portion of the overall global bond market.

Government Bond: A bond issued by a government. Usually refers to bonds issued by governments of developed nations (as opposed to bonds issued by the governments of emerging market nations).

High Yield Bond: A type of corporate bond which is especially risky because the issuer has a credit rating below investment grade. Also known as speculative or junk bonds. High yield bonds have a higher correlation with equities, and during a market crisis are more likely to behave like equities and less like safer bonds (such as bonds issued by the governments of developed economies).

Inflation-Linked Bond: Inflation-linked bonds (ILBs) are primarily issued by governments. ILBs are indexed to inflation so that the principal and coupon payments rise and fall in line inflation, thus providing investors with inflation protection. ILBs underperform their non-inflation-linked counterparts during periods of deflation.

Municipal Bond: A type of government bond issued by a municipality, i.e. any sub-national government entity such as a state, city or county.

Asset Class 3: Alternatives

Alternative financial assets include gold and other precious metals, commercial real estate (commercial property), private equity and venture capital, hedge funds, and commodities. Genuinely alternative financial assets should be (but are not always) negatively correlated to equities and bonds. They act as a kind of insurance but may have negative overall returns. Their purpose in a portfolio is to increase diversification, and this benefit should offset their negative expected returns. For example, when the rest of your portfolio is making losses, you expect these investments to act like insurance and reduce overall portfolio losses. Alternative non-financial assets can include things like rare stamp collections, art, antiques, vintage cars and expensive wines.

Gold and other Precious Metals: Gold is a classic genuinely alternative asset, as are other precious metals such as silver, platinum and palladium. Gold also has industrial uses, so it is perceived as an inflation hedge as well. You can buy physical gold bars and coins (you should then pay to have them professionally insured and stored), but it is relatively cheap and simple to buy a physically-backed gold ETF to get exposure to gold in your portfolio. You can gain exposure to other precious metals such as silver, platinum, and palladium through ETFs as well, but the fees for these ETFs tend to be slightly higher than they are for gold ETFs.

Real Estate: The type of real estate traded on stock exchanges is commercial property – offices, warehouses, retail space and so forth. The real estate sector is fairly correlated to equities, but is still considered a sufficiently diversifying alternative asset in a portfolio. As with equity earnings, commercial property rents also tend to rise with inflation.  As of 31st October 2022, the MSCI’s All Country World Investible Market Index shows that the listed real estate sector accounts for 3.24% of the world’s stock market (in USD, by market capitalisation): https://www.msci.com/documents/10199/b93d88ef-632f-4bdb-9069-d7c5aecd9d6d

By investing in a fund that passively tracks an all-world or a specific regional or country equity index, you will automatically be exposed to the index-level of real estate (worldwide, this is just over 3%). To diversify a portfolio further, you can increase your exposure to real estate by buying a pure real estate fund that tracks a global (or regional or country) real estate index. You can also buy closed-ended funds known as Real Estate Investment Trusts (REITs). REITs invest directly in commercial real estate to earn rental income and management fees. Some also invest in real estate debt (mortgages and mortgage backed securities).

Private Equity and Venture Capital: Private Equity (PE) and Venture Capital (VC) is equity held directly in unlisted firms. Institutional investors can access PE and VC funds directly, but these are usually closed to retail investors and minimum investment sizes are usually too large. There are Private Equity ETFs available to retail investors, but note these ETFs are not investing directly into a PE fund, rather they invest in the shares of listed companies managing PE funds. Hence returns to Private Equity ETFs are much more correlated to the overall equity market than if you had invested directly into a PE fund.

Hedge Fund: A type of fund which uses a strategy of leverage, derivatives and/or short selling (betting on a market of falling prices) and alternative asset classes to generate returns. Most (but not all) hedge funds find their returns are correlated with equities and they perform poorly during market crises. Institutional investors and sophisticated high net worth individuals can access hedge funds directly, but these are usually closed to retail investors and minimum investment sizes are usually too large.

Hedge fund strategies are much more complex than investing in equities and bonds, and they are also much less regulated and far more opaque than other types of funds. It is possible for retail investors to invest in funds including ETFs that attempt to replicate hedge fund strategies, but these are inexact replicas because genuine hedge funds are much less regulated so have access to a much wider range of investment options.

Commodities: As a class of alternative asset, commodities include non-precious metals like copper (used for industrial purposes) oil, and agricultural goods. It excludes precious metals. Like equities, commodity prices tend to rise with inflation. Commodity prices can be very volatile. They are fairly correlated with equities, but still considered a sufficiently diversifying alternative asset in a portfolio.

ETFs that track the price of a multitude of commodity assets are available, including ETFs that track a single commodity such as oil. The energy sector can be viewed as a proxy for commodities. As of 31st October 2022, the MSCI’s All Country World Investible Market Index shows that the energy sector accounts for 5.75% of the world’s stock market (in USD, by market capitalisation): https://www.msci.com/documents/10199/b93d88ef-632f-4bdb-9069-d7c5aecd9d6d

Note that some country indices are much more heavily weighted towards energy stocks than others. For example, as of 31st October 2022, the energy sector accounts for 14.57% of the FTSE 100 (in GBP, by market capitalisation). See the FTSE100 Factsheet at: https://www.ftserussell.com/products/indices/uk

Asset Class 4: Cash

It is also prudent to have easily-accessible cash savings that are totally separate from your investment portfolio(s). Individuals in retirement are commonly advised to keep two years’ worth of spending in cash savings, and for individuals in employment the figure is six months.  Cash is not risk free, its value is eroded over time by inflation. And should a bank collapse, governments are not usually obligated to guarantee 100% safety of citizens’ cash in commercial bank accounts. In the UK currently, only the first £85,000 of cash savings per individual per bank is guaranteed by the UK government’s Financial Services Compensation Scheme (FSCS).

Note that any interest earned on a UK deposit of £85,000 or more will not be protected if the interest accrues to an account within that same bank (see https://www.fscs.org.uk). The UK’s FSCS does however provide coverage for “temporary high balances” (see https://www.fscs.org.uk/making-a-claim/claims-process/temporary-high-balances/).

In the UK, interest on cash savings is counted as a taxable income. In April 2016 the UK introduced a Personal Savings Allowance (PSA) for interest on cash. For basic-rate taxpayers the first £1,000 of interest is tax-free. For higher-rate taxpayers it’s £500, and for additional-rate (45%) taxpayers, there is no PSA at all.

Please note, when investing, your capital is at risk, and returns are uncertain. The information in these blog posts does not constitute financial advice and should not be considered as such.