What is an Asset Class?

Navigating the Universe of Investments

When thinking about investments, most people imagine one thing: 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 where to focus your efforts.

1. The importance of Asset Classes

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.

The main asset classes are:

Equities: Also known as stocks, equities represent ownership in a company. They are considered high-risk investments, but they also have the potential for high returns. Equities are often used to build long-term wealth.

Fixed income: Fixed income investments, such as bonds, provide a fixed rate of return over a set period of time. They are generally considered lower-risk investments than equities, but they also offer lower returns.

Cash and cash equivalents: Cash and cash equivalents are highly liquid investments that can be easily converted into cash. Examples include savings accounts, money market funds, and certificates of deposit (CDs).

Real estate: Real estate investments can include direct ownership of property, real estate investment trusts (REITs), and real estate mutual funds. Real estate investments can provide a steady stream of income through rental payments and can also appreciate in value over time.

Commodities: Commodities are physical goods that are traded on commodity exchanges. Examples include gold, silver, oil, and agricultural products. Commodities can be used to diversify a portfolio and provide a hedge against inflation.

2. Asset Class synergy

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 in 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 the asset classes had positive real return expectations and consistent negative return correlation with each other. Unfortunately, that is not the case. 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-year horizon

3. Learning from the past: asset class performance history

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. The historical returns of various asset classes from 1985 to October 2020 are:

4. The Business Cycle can influence asset class behavior over time

The business cycle is a pattern of economic expansion and contraction that occurs over time. It is characterized by four stages: contraction, trough, expansion, and peak.

The contraction phase is characterized by a decline in economic activity, and it is also known as a recession. During this phase, bonds and cash tend to perform well, while equities and commodities may underperform.

The trough phase marks the end of the contraction phase and the beginning of the expansion phase. In this phase, the economy has reached its lowest level of growth, and there is a gradual increase in employment, production, and consumption. During this phase, equities and commodities may start to perform well again, while bonds and cash may start to underperform.

During the expansion phase, the economy is growing, and there is an increase in employment, production, and consumption. In this phase, equities and commodities tend to perform well, while bonds and cash may underperform.

The peak phase marks the end of the expansion phase and the beginning of the contraction phase. In this phase, the economy has reached its maximum level of growth, and there is a decline in employment, production, and consumption. During this phase, commodities and equities may continue to perform well, but bonds and cash may start to outperform.

The Expansion and contraction phases can be further broken down into early and late stages. The following chart is a useful guide to understanding these transtions:

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 move in the same direction at the same time. 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.