This fact sheet provides additional information to help with understanding the investment, tax and other financial planning concepts that we have discussed with you or included in your Statement of Advice.
Please contact your adviser if there is any aspect on which you need further information or clarification.
What are asset classes?
An asset class is a group of securities which exhibit similar characteristics and market behaviour. Below is a brief description of the major asset classes.
Cash, Deposits & Money Market Instruments
Cash generally refers to investments in bank bills and similar securities with short investment time-frames. They provide stable, low-risk income in the form of regular interest payments.
Credit quality refers to an entity's ability to repay debt. The safety of a cash deposit is linked to the financial strength of the deposit bank. Rating agencies such as Standard & Poors (S&P), Fitch, and Moody's analyse the credit quality of institutions and assign a rating that estimates the probability of loss.
An investor can decrease the risk of holding cash by diversifying the cash allocation across multiple issuers and investing in 'cash equivalents'.
Money market funds are collective investment schemes which invest money in cash or cash equivalents with high credit quality. These typically include US Government Treasury Bills, bank certificates of deposit, bankers' acceptances, corporate commercial paper, and other money market instruments.
By investing in cash equivalents issued by a broad range of issuers, these funds allow investors to diversify their allocation to the cash asset class away from concentrated exposure to a small number of institutions.
Fixed Income
The fixed income asset class encompasses investments in which an investor lends money to a government or company for a defined period in return for regular payments based on fixed or floating (variable) interest rates.
The most common type of fixed income instrument is the vanilla bond. Hybrid securities, asset-backed securities (ABS), commercial loan obligations (CLO), mortgage-backed securities (MBS) and floating-rate notes (FRN) are also common.
Bonds are a source of regular income, as their returns are more predictable than other investments. The downside is that returns tend to be lower than those of different asset classes, especially over the long term, and they do not protect the investor's capital from inflation.
Bonds have a nominal or par value, typically 100, which is the sum that is due to be returned to the investor at maturity. Except in the case of inflation-linked bonds, known as 'linkers', the par value is not adjusted for inflation. While the market price of a bond fluctuates with interest rates, inflation expectations and the credit quality of the issuer, as the bond approaches maturity it tends to converge towards its par value.
While bonds present a lower risk than equities, they are not risk-free.
For example, bonds that pay a fixed rate of interest are subject to interest rate risk. As market interest rates rise, the value of a fixed rate bond tends to fall, and the yield on that bond increases in line with the market.
To understand how sensitive a bond is to movements in market interest rates, we use a measure called 'duration'. Duration is expressed in years, and affected by the amount of time to maturity and amount of income that the bond pays. While a government bond and a high yield bond may mature on the same date, the high yield bond would likely have a lower duration due to the higher coupon. The higher a bond's duration, the greater it's sensitivity to interest rate movement.
Credit Default Risk is the risk that the issuer of a bond will not make the interest payments and repay the full par value of the bond at maturity. The credit spread reflects this risk. A credit spread is an additional yield that the market (investors) requires above government bond rates of the same maturity.
One way of mitigating interest rate risk is to invest in a floating-rate note. A 'floater' is a type of bond where the interest rate paid is variable, and usually tied to a benchmark such as the Australian bank bill rate or the US Treasury bill rate. As market rates go up or down, the interest rate on the bond changes at regular intervals, e.g. quarterly.
Fixed income products typically play a significant role in investment strategies that target the generation of steady cash flows or the preservation of capital. The downside is that returns tend to be lower than those of other asset classes, especially over the long term.
While investors can invest directly in bonds, a common way to access this asset class is via collective investment schemes such as ETF's, managed funds, investment trusts or listed investment companies. Managers of these funds can invest in many different types of bonds, across a broad spectrum of issues, countries, sectors and duration, and incorporate currency hedging strategies.
Investing via a collective investment allows investors to diversify away a significant amount of risk and opportunity cost involved in having a concentrated portfolio of bonds issued in one jurisdiction and one currency.
Equities
Equities, also known as stocks or shares, are units of ownership in a company. When investors buy the shares of a company, they own part of the company and become its shareholders.
Equities provide an investor with the potential for capital growth and income. On the downside, share prices tend to fluctuate more than other asset classes.
In contrast to bonds, which generally pay a fixed rate of return, returns to shareholders are highly variable. This variability can be true of the dividend income, but particularly the amount and timing of the return of the investors capital. Both income and capital returns from shares are linked to the fortunes of the company and expected to increase in line with profitability and free cash flow.
Capital returns are also highly dependent on the market price at the time the investor sells their shares. The market price of a share is affected by supply and demand, which is influenced by the market assessment of:
- Company-specific factors - such as the number of shares on issue, the quality of the company's management, its profitability, the strength of balance sheet, and competition within its sector.
- Sector-specific factors - such as the demand for a company's products, commodity prices, and changes in technology;
- Macroeconomic factors - such as the strength of the local and global economy, exchange rate movements and interest rates.
Investors can invest in shares directly, or via collective investment schemes such as investment trusts or investment companies, commonly known as ETFs, managed funds or mutual funds. Managers of these funds can invest in many different types of bonds, across a broad spectrum of issues, countries, sectors and duration, and incorporate currency hedging strategies.
For more information, refer to Understanding Equities.
Alternative Investments
In the context of portfolio management, the traditional asset classes are cash, fixed income and equities. The term Alternative Investments refers to other asset classes such as property, hedge funds and private equity.
Perhaps unfairly, given the complexity and volatility that can reside in the traditional asset classes too, Alternative Investments are usually considered more complex investments.
Alternative investments do, however, expose investors to additional risks that require consideration, including liquidity risks, counterparty risks, manager risks and leverage risks. These are not always apparent from fund documentation, which may also be lighter on detail than traditional asset classes if the investment is offered only to sophisticated investors.
Property
An alternative to direct property investment is to gain exposure via financial instruments.
Property securities are fractional interests companies or trusts that own commercial, retail, industrial or residential property. These companies or trusts may list their shares or units on a stock exchange, but it is common for them to be unlisted.
The most common form is the Real Estate Investment Trust or 'REIT'. An equity REIT purchases properties to generate rental income and capital growth. A mortgage REIT does not purchase properties; it invests in mortgages and collects interest income.
As with investing in property directly, the risks include those posed by rising interest rates, tenants defaulting on rental payments and maintenance costs being higher than anticipated. Property securities can be illiquid, and it may be challenging to find a buyer for your units when you wish to sell, particularly if the vehicle is unlisted. Exposure to construction or development activities, via equity or debt, also increases the risk profile.
As with direct investment, the investment manager will often use leverage to acquire the properties held by a REIT. If property values fall or the company cannot refinancing their existing loans, the company may call for more capital or default on their loans, causing the loss of some or all of your investment.
Commodities
Commodities are 'homogenous' assets that do not vary to a large degree from producer to producer. They conform to a standard measurement and grade of quality - for example, a barrel of oil or a tonne of iron ore.
Future exchanges host the bulk of the trading in standardised commodity contracts. Supply and demand determine the value of a contract for a specific commodity, along with interest rates and the cost of storage for the period between trade date and settlement date.
Commodity prices can be volatile and fluctuate substantially if a natural disaster, such as a hurricane or an earthquake, affects their supply or production. Not all commodities exhibit the same characteristics. Investors often view gold and other precious metals as a store of value and safe havens during times of crisis or uncertainty.
Hedge Funds
Hedge funds are collective investment schemes that aim to generate returns that do not correlate with the returns of traditional asset classes.
Traditionally, hedge funds were domiciled in offshore jurisdictions such as the Cayman Islands, with limited liquidity and relatively high fees. They were available only to sophisticated investors. Hedge fund managers enjoyed a great degree of flexibility in terms of investment selection, asset allocation and trading styles, with the rationale being to generate positive returns throughout the cycle by responding to a broad range of conditions in a broad range of markets with a wide range of strategies.
Since the Global Financial Crisis in 2008, where many offshore hedge funds either blew up or restricted redemptions, the use of hedge fund strategies in well-regulated jurisdictions such as the European Union has gained popularity.
Typically known as absolute return funds, the hedge fund managers still have a flexible investment mandate but are restricted by minimum requirements for liquidity, leverage and counterparty risk management.
Hedge Funds commonly use derivatives for leveraging returns and engage in practices such as 'shorting', where the potential for loss is theoretically unlimited. 'Shorting' involves borrowing a security and selling it in the expectation that it will fall in value, at which point you buy it in the market and return it to the lender.
As well as the risks posed by leverage and shorting, given the unconstrained nature of most hedge fund strategies, Manager Risk is a key risk to consider when investing in hedge funds.
Private Equity Funds
Private Equity (PE) funds are unregulated collective investment schemes that typically invest in private companies.
Investment in PE funds is typically by way of commitment, whereby an investor agrees to invest a certain amount in the fund over the investment period. This amount is drawn down gradually by the fund as and when it is needed to make investments.
PE funds tend to be closed-ended and have finite lifespans, typically 5-7 years with the option of one or two 2-year extensions. During the life of the fund, it is usually not possible for investors to redeem their money, meaning that it can be several years before investors realise a return on their investment. For this lack of liquidity, PE investors typically expect a higher return.
Returns are dependent on the performance of the companies in which the fund invests. The company selection and transaction structuring skills of the manager are, therefore, important drivers of return. Leverage is often used by the PE fund to acquire portfolio companies, which increases the risk of the investment.
Whilst returns may be higher than other investments, investment in PE funds involve a high degree of risk and are only suitable for investors who fully understand and are willing to take on those risks, including the lack of liquidity.
Common financial instruments
Some financial products are not considered asset classes in their own right but facilitate investment or incorporate asset classes in a complex and combined structure. These products are generally known as financial instruments.
Foreign Exchange
Foreign exchange trading - buying one currency in exchange for another - serves three main purposes.
- It facilitates the settlement of investments in foreign currencies
- It helps to manage risk by allowing investors to hedge their foreign currency exposures arising from foreign investments.
- It enables traders to speculate on exchange rates and interest rate differentials, with the aim of generating capital gains.
Speculative foreign exchange trading exposes investors to Foreign Exchange Risk, as desired, which can be volatile and driven by a variety of economic factors. This risk may be magnified by the use of leverage, in the form of foreign exchange options, forwards or futures.
Derivatives
Derivatives are financial instruments that derive their price from an underlying asset or instrument. Examples of derivatives include options, futures, forwards, warrants, options and swaps.
Although some investors buy derivatives to speculate, they are generally used to manage risk, which is known as hedging. For example, an investor purchasing foreign shares may be exposed to adverse currency movements. To hedge this risk, they could sell that currency forward, against their home currency, to secure a specified exchange rate.
While hedging reduces the investor's risk, the cost of the hedge typically reduces the investor's potential return. The investor can reduce this cost by capping their return at a certain level, again using derivatives.
Structured Products
Structured Products refer to a wide variety of financial products that are structured by financial institutions to offer return profiles that differ from traditional asset classes and securities.
In most cases, a debt instrument and one or more derivatives are packaged together in a structured product. They have a fixed investment term, with the potential for early redemption or cancellation in some cases based on specific triggers. The structurer may design the product to provide income, capital growth or both.
A typical example is a capital-protected note. For example, an investor would like to buy $100K of BHP but wants to protect their downside risk. They could buy an at-the-money BHP call option for their desired investment term (5 years), paying the premium upfront.
Alternatively, a bank will build a structured product. The client will pay the bank $100K, and the bank will issue a zero-coupon bond. The price of the zero-coupon bond is $90, and it will return $100 to the investor in 2 years, leaving $10 available now for the 2-year at-the-money BHP call option (and the bank's fee). In 2 years, assuming the issuer is still solvent, the investor receives the $100 back, plus the return on the option.
The risks of structured products vary greatly, depending on the type of payoff and the underlying; however, the most important risk to consider is Issuer Risk. In the example used above, the investor's has invested their money with the bank, not BHP. If the bank fails, the investor will likely not receive their money back.
Important Information
Walbrook Wealth Management is a trading name of Barbacane Advisors Pty Ltd (ABN 32 626 694 139; AFSL No. 512465). Barbacane Advisors Pty Ltd is authorised to provide financial services and advice. This post is general information only and is not intended to provide you with financial advice as it does not consider your investment objectives, financial situation or needs, unless expressly indicated otherwise. You should consider whether the information is suitable for your circumstances and where uncertain, seek further professional advice. The author has based this communication on information from sources believed to be reliable at the time of its preparation. Despite our best efforts, no guarantee can be given that all information is accurate, reliable and complete. Any opinions expressed in this email are subject to change without notice, and we are not under any obligation to notify you with changes or updates to these opinions. To the extent permitted by law, we accept no liability for any loss or damage as a result of any reliance on this information.
