What is an asset class?
A simple way to define an asset class is to break it into two single words and examine the definition of each. In the Oxford Dictionary, asset is defined as a âuseful or valuable thing, person or qualityâ or âproperty owned by a person or company, regarded as having value and available to meet debts, commitments or legaciesâ. Class is defined as âa set or category of things having some property or attribute in common and differentiated from each other by kind, type or qualityâ.
As per the dictionary, an asset class is a category of valuable things that share common attributes and can be differentiated from other asset classes. Using more financial language, an asset class is defined as a broad group of securities or investments that exhibit similar characteristics, tend to behave similarly during different market conditions and are subject to the same laws, regulations and legal definitions. Each asset class is expected to reflect different risk and return investment characteristics and to perform differently during different market conditions.
A distinction should be made between assets and investment assets. Assets can be a range of valuable things, such as a smartphone, a car or a dishwasher. Each of these delivers utility to its owner.
Investment assets also deliver utility, but it is a financial or monetary utility. Equities, bonds and cash deposits, for instance, provide dividends, interest and potential capital appreciation. Some investment assets provide more than just monetary utility. Owners can live in their residential property while enjoying possible price appreciation. The focus in this book, of course, is on investment assets.
Asset classes can be distinguished in various ways and classified using different classification frameworks. Traditional asset classes, typically the most commonly used assets in portfolios, include equities (stocks), bonds (fixed income securities) and cash (including cash equivalents and money market vehicles).
Alternative investments are best classified as non-traditional assets. They include asset classes or investment types such as real estate (often classified as a traditional asset class) and commodities. Private equity is an alternative asset class but is sometimes considered a sub-asset class of equities, which is comprised of publicly traded equities and privately owned equities.
Hedge funds fall under alternative investments, but are not an asset class. Rather, hedge funds have different exposures to different asset classes. They are best described as a series of characteristics, including usually flexible actively managed investment vehicles that use derivatives and investment techniques such as leverage and short selling. Hedge funds are not a separate asset class per se.
Other more esoteric, less common and more ambiguously classified alternative investments include currency, infrastructure, securitised investments (e.g. asset-backed securities (ABS) and mortgage-backed securities (MBS), which can potentially be classified as fixed income), leveraged loans, volatility, art (including different collectibles such as stamps and wine), insurance-linked securities, timber and alternative or smart beta.
Asset class in its broadest definition can include intellectual property (i.e. intangible assets), such as patents, trademarks, copyrights and goodwill. Human capital can be considered an asset as well, since it can be a source of income and it can be valuable. These assets can be included on the balance sheets of corporations or individuals. However, they are not considered investment assets and are therefore out of this bookâs scope.
Asset classes with a low correlation to the investment opportunity set of traditional or common assets provide the largest diversification benefits within portfolios, and this is one of the drivers in the ongoing quest to find such assets. Financial innovation, such as derivatives and securitisation, technological developments, such as the internet, and falling expected returns and increasing risks of traditional asset classes have resulted in continued expansion of the asset universe. More and more assets and investment types are becoming accessible to investors.
Real and capital assets
Asset classes fall into two broad categories of real assets and financial or capital assets. Real assets are things that you can touch; they are tangible. Real estate (i.e. buildings), commodities and art are real assets. Financial or capital assets are intangible assets, deriving their value because of contractual claims.
These days, financial or capital assets are no longer represented by a piece of paper (e.g. a stock certificate), but rather by information held on computers. Examples include equities, bonds and cash. Capital assets are normally much more liquid than real assets and they are commonly traded on financial markets. Derivatives on commodities and real estate are a transformation of rights on real assets into financial assets.
The economic function of capital assets, such as equities (ownership in companies) and corporate bonds (liabilities of companies), is to raise external resources or financing for companies. Investors in these securities are either the companyâs shareholders or debt holders, bearing the risk that the future cash flows generated by the company may be lower than expected and may cease to occur during bad times, such as recessions. Investors expect to be compensated for taking such risks. These assets represent the discounted value of future cash flows. Their value depends on the decisions of corporate managers and the commercial fortunes of the issuing company.
Real assets, such as property and commodities, are different; they do not raise financial resources for companies. Rather, property and commodities are the basic resources allowing companies to operate and influence the future value of their outputs (or inputs). Investors in property and commodities receive compensation for bearing the risk of short and long-term property and commodity price fluctuations.
No matter which type the asset is, the common attribute of capital and real assets is that investors in these assets assume risks and expect to be compensated for taking these risks. The types of risks and their levels are different and hence the expected and realised rewards are different. As the distribution of potential outcomes is wider, the risk is higher. According to basic financial theory, when the risk is higher the required potential reward must also be higher to attract investors to assume the risk.
Super asset classes
Robert Greer proposes a classification framework based on three super asset classes: capital assets, consumable/transformable assets and store of value assets:
- Capital assets, such as equities, bonds and real estate, generate a stream of cash flows and their value can be measured by calculating the present value of these cash flows.
- Consumable/transformable assets, such as commodities, do not generate a stream of future cash flows, but rather a single cash flow when they are sold or utility when they are consumed.
- Store of value assets, such as currency and art, do not generate cash flows and cannot be consumed, but still they have a monetary value.
The borders separating super asset classes may sometimes be blurry. For example, precious metals, such as gold, are both consumable/transformable and store of value assets.
Income and price appreciation
The reason for investing in assets or investments is to generate returns. Total returns are made up of two components: income and price appreciation. Some assets are more focused on generating income, such as fixed income investments. Other assets do not generate any income and their return is solely dependent on potential price appreciation. Commodities and art are examples of investments that do not generate income. Most assets, such as equities, deliver a combination of income (e.g. dividends) and potential price or capital appreciation.
Income is usually more reliable and predictable than price appreciation. For some assets, such as government or corporate bonds, income payments are mandatory contractual obligations and will be paid as long as the issuer can make the payments.
Potential price appreciation, as it says, is only a potential. It depends on the prevailing price of the asset as determined by market forces (supply and demand) at the time that the asset is sold.
Income is a positive nominal return, albeit it can fall to zero; for example, if a company stops paying dividends on its stock or defaults on its debt obligations. Real income can be negative due to inflation. Price appreciation can be negative (i.e. price depreciation).
Where price appreciation is a larger component in the total return of an asset, the larger is the risk of a negative total return, all else being equal. Because of the relatively lower risk of income compared to price appreciation, as income becomes a larger component in the total return of an asset, the lower becomes the total expected return, all else being equal.
Income is a significant component of total returns and as the investment horizon becomes longer, income becomes a more dominant component of total return over capital appreciation. Gold, for example, as a non-income producing asset, typically falls short of equities and real estate in the long term primarily because of its lack of income.
Income can provide an element of a lower-risk return compared to capital appreciation and income-producing assets can offer more stable returns over time. This means income can be regarded as a buffer or a safety net. Capital appreciation, on the other hand, can offer material potential returns â capital appreciation is a potential growth engine. Assets can be distinguished, therefore, by their income and price appreciation characteristics.
Risk and conservative assets
A helpful framework for classifying assets is by risk assets (growth assets) and conservative assets (safe assets). Risk assets, as their name implies, have a higher level of risk compared to conservative assets. The challenge is how to define risk and how to measure risk.
Different assets entail different types and levels of risk. Risk is a multifaceted concept and includes different factors and measures. The three main risk categories are market risk, credit risk and operational risk.
Investment risk is usually measured by volatility of returns. Volatility measures the dispersion of returns without differentiating between unwanted returns below the mean and wanted returns above the mean. Downside risk measures, such as Value at Risk (VaR), focus on the negative, bad returns. When returns are symmetric, volatility is typically strongly associated with downside risk.
Liquidity risk is yet another dimension of risk that is not necessarily captured by volatility. Some illiquid assets, such as real estate, appear to have low volatility because their returns are smoothed due to appraisal-based valuations that are anchored to the last known prices. However, considering only the volatility of real estateâs past returns, without c...