People usually think of one thing, and one thing only, when confronted with the word investment: the S&P500. The common passive fund manager replicates the S&P500. But there is a whole universe of assets out there to invest in and/or trade. We believe you should know what options you have, before deciding what to focus on.
An asset class is a group of securities that have similar financial characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. Capital markets are composed of different types of asset classes. Typical asset allocation involves dividing an investment portfolio among different asset classes based on an investor's financial requirements. The right mix of asset classes in a portfolio provides an investor with the highest probability of meeting their financial goals. Each asset class selected has a long-term expected return over inflation, known as the real return.
Risk/Return characteristics of the various asset classes
The main asset classes are:
a) Equities: also called stocks, they represent shares of ownership in publicly held companies. The have historically outperformed other investments and tend to be very volatile in the short term.
b) Fixed Income: also called bond investments, they generally pay a set rate of interest over a given period, and then return the investor’s capital. They have historically been less volatile than stocks, and their fluctuations are based in interest rates and inflation rates.
c) Money Market: money market investments are usually the "safest" investments even though they are illiquid. Examples are government issued securities, certificates of deposit, & commercial paper. Of course, they also have lower potential for growth.
d) Commodities: marketable items produced to satisfy wants or needs, like coffee, orange juice, pork bellies, crude oil, heating oil, etc. In order to further diversify their investments and mitigate the risks, an increasing number of investment funds are allocating more capital to non-listed assets such as a commodities. Commodities tend to perform well during global supply shocks.
e) Currencies: we have already spoken about currencies as an asset class in a prior article so we’ll just report the main findings here. We could argue that beta in it’s traditional meaning does not apply to the FX universe, and that factor models should apply. After all, non-zero long-term returns come from betas associated with economic value production. Equities are a call on profits from making and selling goods & services. Bond yields are a sort of tax on economic growth, which means that high prices act as an engine to growth. FX betas are more risk-factors so the debate is still open.
Since not all asset classes sing to the same tune, some may be rising while others are falling. Knowing how a certain asset class typically behaves (and has behaved in the past) can help you understand what to expect given the current economic environment and market dynamics. Stocks and bonds are the two major categories used in portfolio diversification. The amount that an investor should have in stocks and bonds is based on two factors. First, the allocation is based on the expected return that an investor requires to meet their financial objective, and second, it is based on the amount of investment risk that a person can accept. But recent literature has shown that the usual 60/40 stocks/bonds allocation actually ends up with a concentrated risk profile, with over 90% of portfolio volatility coming from equities and with returns coming essentially from the equity risk premium.
Asset allocation analysis requires a correlation study between asset classes. Correlation analysis shows how the price of one investment has historically moved in relation to the price of another. If two asset classes moved in the same direction at the same time they had positive correlation. If the returns had moved in different directions at the same time, they had negative correlation. It is logical to not invest money on assets that tend to perform in the same fashion (directly correlated) because this essentially increases the investor’s exposure to the same risk factor. Asset classes can be mixed efficiently, in order to diversify these risks.
Correlation is not a fixed number. It changes over time and in unpredictable ways. It would be ideal if two asset classes had positive real returns expectations and consistent negative return correlation with each other. Unfortunately, there are no such pairs of investments. A rolling correlation study shows that the correlation between any two asset classes tends to shift over time and in an unpredictable way. Based on past data, we can only loosely predict what the correlation between two asset classes might look like.
A correlation matrix between asset classes ( as represented by ETFs) over a 1-month horizon
A correlation matrix between asset classes ( as represented by ETFs) over a 1-year horizon
It’s interesting to notice how correlations can change over time. The correlation changes are usually dictated by market drivers: what the market is focused on at any one point in time.
The classical Stock/Bond inverse relationship applied to DAX/BUND.
Historical average returns are a common starting point for judging future performance and behavioral traits of asset classes. The idea is that the more consistent an asset class’ behavior over time, the more reliable we can expect it to be in the future.
What are the natural criticisms?
Any sample period can be biased by some driver or some exceptional performance that does not necessarily mirror the usual behavior of the asset class.
Longer historical windows reduce the sample period bias, but structural changes and data quality can make older data less relevant.
Cyclicality (i.e. The Business Cycle) can influence behavior over time.
But, we need to start somewhere so before going into the charts that we all love, here are the main take-aways:
equities have outperformed bonds during the past century.
Long term bonds have outperformed short term bonds.
Value investing, Carry Trading, Momentum active trading strategies have all proven to generate consistent returns over time.
Most importantly, as a famous insurance company reminds us, things happen and when things happens, all asset classes become one: the S&P500. And it gets sold.
Each asset class responds differently to underlying economic conditions and market dynamics, and will perform differently at a given point in the business cycle. We are not going into detail here on intermarket correlations or sentiment reading (which you can learn in the Mindset Lessons), but the main takeaways are:
a) simple is usually better. Sentiment reading is usually easier on equities and equity indices, rather than on more complex asset classes like commodities and currencies.
b) choose you battles wisely: don’t get stuck trying to understand and trade an asset class that is not in line with the current economic conditions.
c) elevated risk perception demolishes all correlations: everyone shorts the S&P500 (or a proxy like YM).
To sum up: An asset class is a group of securities that have similar financial characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. Not all asset classes sing to the same tune, some may be rising while others are falling. Each asset class responds differently to underlying economic conditions and market dynamics, and will perform differently at a given point in the business cycle. In the Mindset Lessons, you can learn more about intermarket correlations and underlying conditions, which are essential to proper planning. But at least now you know that not all investments are created equal!
©2014 Vertex Trading Systems LLC