Asset Classes and Investment Options

Utilizing the lessons of diversification, you may want to construct a portfolio consisting of holdings from a variety of asset classes. While they are some disagreements, an asset class is a collection of securities which possess similar characteristics, behave similarly in the market and are subject to the same laws and regulations. In this document, we will describe some of the key asset classes that you will want to consider when constructing your portfolio.

Equities

• Domestic equities: Domestic equities are common stock held in publicly traded companies which operate primarily in the United States. Owning the equity grants the holder the rights to any dividends or other distributions that the company makes. Equities are more risky than bonds since the bond holders have first call on the company’s assets if a bankruptcy and liquidation occurs. The equity holders can be left with nothing if a company liquidates (see Enron). Most people will subdivide the domestic equities market into more asset classes based on the size of the company (generally represented by the market capitalization) and the value/growth split. Value stocks are stocks that appear under-valued using some ratio such as price/earnings or book value to market cap. Growth stocks are companies with a higher than average rate of growth in their revenue, earnings or distributions. Thus, several combinations of size and value/growth behavior exist. There are several exchanges where these stocks trade and many indices which track the performance of equities in each particular asset class.

• Developed market equities: These include equities of companies which operate primarily in Europe and several of the countries in the Pacific Rim. The economies of these countries are generally less volatile than developing countries. There are several indices for the developed markets. Morgan Stanley has one called the MSCI EAFE index.

• Emerging market equities: This class includes stock in companies based in developing countries like Brazil, China and India. The economies of these countries can be very volatile and they generally don’t have as many investor protections through auditing and securities law as exist in developed markets.

• REITs: REITs are Real Estate Investment Trusts. These are funds that make investments in real estate (both commercial and residential). They will generally generate higher levels of dividends since their investments will typically be paying them income from rents and leases. Since the distributions are higher, REITs behave somewhat like a hybrid between a traditional equity and a fixed income instrument. They will generally have higher expected returns and higher variance than most fixed income instruments.

Fixed Income

• U.S. Treasuries: U.S. Treasury bills and bonds promise to pay the holder a certain annual rate of return. They can be purchased directly from the Treasury or on the market. The annual return rate that the bond will pay is usually referred to as the yield of the bond. Investors can typically gain exposure to bonds by directly purchasing individual bonds to form a bond ladder or investing in a bond fund. Bond funds typically contain a portfolio of bonds with similar maturities. Bonds from the U.S. government are generally a less risky asset than equities (their variance of returns has been lower over time) but produce lower rates of return.

• U.S. Treasury Inflation Protected Securities: In recent years, the U.S. Treasury has introduced a new fixed income product. The annual payments on this instrument are linked to the rate of inflation. Thus, the investor will be guaranteed a certain real rate of return on this asset class. These can be very useful when you want to have a hedge against inflation in your portfolio.

• Foreign Bonds: Just as the United States will offer bonds to fund the operations of the government, foreign countries will sell bonds as well. The investor is taking on a couple of risks with foreign bonds. First, the bonds are dominated in the foreign country’s currency so there is some currency risk. Secondly, changes in interest rates for that country will impact bond prices.

• Asset-backed securities: There are a host of fixed income securities whose payments are backed by assets. One example is mortgage-backed securities. These securities generally will make periodic payments to the owner of the security. There is an asset (like a house in the case of mortgage-backed) which provides collateral in case there is a non-payment by the party which has entered into the payment arrangement. These securities are often offered by financial institutions which have created the security from a bunch of underlying assets (the mortgage agreements in our example) which they have purchased.

Special Classes

• Commodities: This asset class covers a wide range of items which are considered commodities. These items include oil, gold, silver, wheat, coffee and rubber. There are indexes based on a bundle of such commodities.

• Private equity: Private equity includes many different classes of assets. Leveraged buyout funds, venture capital funds and hedge funds would be some examples. Many of these are not available to individual investors as the minimum investments can be quite large while other funds will only take investments from invited investors. These funds will often make financial transactions that involve private companies.

Asset Classes in Your Portfolio

There are many views on the right number of asset classes to hold. Here are three sample opinions:

• John Bogle (founder of Vanguard): Bogle seems to think that you get enough diversification by owning just two things: the total U.S. bond market index and the total U.S. equity market index. In his thinking, you’ve got REITs covered by owning the whole equity market. Foreign markets are covered since U.S. businesses do a good chunk of their business with foreign customers. He is somewhat open to higher international exposure but hasn’t seen international returns that justify the move (his opinion on this was written in 1999). Since he’s the founder, you’ll find that Vanguard’s funds seem to stick to a similar strategy (like the Target Retirement Fund).

• David Swensen (runs the Yale endowment): Swensen believes that the individual investor can achieve ideal diversification with 6 major asset classes (domestic equity, foreign developed equities, emerging markets, REITs, U.S. Treasury bonds, Treasury Inflation protected bonds). He thinks other bonds don’t perform well enough on a return/risk measure to benefit the individual investor. It’s not clear what his stance is on commodities but some work has been done recently that shows that adding commodities would help a generic portfolio. We summarize some of his other arguments about asset classes at our review of Unconventional Success.

• William Bernstein (author of the Intelligent Asset Allocator): Bernstein likes to use a lot of asset classes. For people really interested in investing, he would suggest over 20 different asset classes. He includes all sorts of bonds and he slices and dices the equities markets by size, location and value/growth.

All these guys are experts on investing and serious thinkers. They all make persuasive arguments and we think that investment data is such that each can justify his argument with data over certain periods of time. In our opinion, Swensen makes the most compelling arguments — because he actually goes asset class by asset class and discusses the pros and cons of each. Plus, we think 6 classes are very manageable from an individual’s standpoint.

Investment Strategy Options

In the absence of confidence in the ability to select assets or managers which will out-perform the market, we believe in an investment strategy that is based on building a portfolio of elements of several asset classes. To capture the benefits of diversification, you will want to choose asset classes that are somewhat uncorrelated. For young investors, the portfolio should be weighted towards equities as these generally have the highest mean returns.

With these ideas in mind, you have a few options for building such a portfolio. Let’s describe three and point out some of the pros and cons.

• Buy individual stocks and bonds: If you believe that your picks can beat the market, this might be a good strategy. Bear in mind that most people who think that they can beat the market will fail. Secondly, if you don’t purchase enough different uncorrelated stocks, your portfolio may not be properly diversified and have higher return variance. This is a real concern since investors typically choose stocks based on their expected return instead of considering diversification implications. Finally, beware of racking up high trading expenses if you turn over your portfolio frequently.

• Portfolio of actively traded mutual funds: Mutual funds offer a means for easily constructing a diversified portfolio. There are an enormous number of mutual funds to choose from. They cover all asset classes. However, as discussed previously, mutual funds suffer because of their higher expense ratios and several other factors which create a drag on their performance. We would caution the investor who believes that he can identify managers who will consistently beat the market. The odds are against you.

• Portfolio of index funds and ETFs: In our opinion, this is the best approach. You will reap the benefits from diversification (if you properly construct your portfolio) and has the opportunity to get performance which will be very close to the market. There is little risk of under-performance in the long term since your objective is to merely match market performance. Your funds should out-perform over 90% of mutual funds in the long term. We explain this strategy in more detail at Sigma Investing Strategy.