Different types of assets provide returns in different ways with their own set of risks attached. By building a deeper understanding of what kinds of asset classes exist and how each of these work, we can better manage our investment risks and returns and make them more aligned with our financial goals. Before we get into the details, though, we need to start at the beginning.
What is an Asset Class?
Assets are broadly categorised into different classes that share the same basic characteristics. The main asset classes are cash or cash equivalents, fixed interest, property, shares, and another class often called “Alternative Assets”. Investments in each respective asset class tend to have differing risk and return characteristics. The following information sets out each asset class and briefly identifies what they include and what risks and returns you might expect. We also look at why it’s a good idea to own a range of investments across a mix of asset classes.
What are the main types of Asset Classes?
1. Cash
When we hear “cash”, people normally think of money in our bank accounts or literal hard currency. This is correct but cash or cash equivalents when considered in an investment context also includes cash at call, short term deposits, or holdings in a fund that invests into similar short term assets. These funds can also include short term Bills issued by the New Zealand Treasury which are difficult for retail investors to access.
Non-currency cash assets are a form of debt security. Investors receive rent for lending their money in the form of interest.
Cash assets are low-risk assets that are stable in value and are readily accessible or that become available (or mature) within one year or less. As an asset class, cash assets enjoy the lowest risk of loss (of the asset itself). On the other hand, it’s also the asset class most at risk of losing value due to inflation. That’s because, by definition, the purchasing power of cash falls as prices rise.
2. Fixed Interest
Fixed interest refers to a debt investment. This is where an investor lends their money to someone and is paid a "rent" for its use. This rent is generally called interest but is sometimes referred to as a "coupon". The loan may be for a set period and at a set rate of interest or it may be indefinite with a way of changing the rate of interest over time.
Within the fixed interest asset class we find term deposits, personal and commercial loans, bonds, capital notes and preference shares of varying sorts. Each of these has differing features. They may be offered by differing organisations such as Central Government, the Local Government Funding Agency, directly by a local authority (e.g. Auckland City Council), or by a company (e.g. Auckland Airport). These are called “issuers”. The combination of features of a fixed interest asset and its issuer will give rise to the specific risks of the investment.
Fixed interest assets do not offer any growth, just the income. Many fixed interest assets, but not all, can be bought and sold (traded) on a debt market. In New Zealand a debt market called NZDX is operated by NZX, the operator of the main share market. NZDX mostly trades assets issued by companies, Government and some local authorities. Most countries will have one or more debt markets. In New Zealand the Government operates a market for its debt. Some financial institutions also “make a market” for fixed interest assets.
You can own some, but generally not all, fixed interest assets directly, yourself, or indirectly through a fund. Some fixed interest assets are only available to wholesale investors (typically large funds or institutions) due to the large minimum parcels offered or due to regulatory issues.
Some fixed interest assets such as term deposits are rarely traded. Most other fixed interest assets are traded, however, and the prices of fixed interest assets can therefore rise and fall on debt markets. This can happen through changes in interest rates, changes in the creditworthiness of the issuer, and forces of supply and demand, for example.
3. Property
Property refers to the ownership of real estate which can include bare land, houses, commercial buildings and special use properties such as farms, orchards, vineyards, forests, and recreational space such as golf courses, just to name a few.
Investment property, as opposed to an owner-occupied home, normally gives an investor an income from rent. This rent can be bid up over time which should enhance the capital value of the property.
Tangible assets like this are considered “real” in the sense that you can see and touch them which gives property an inherent value when compared to other assets that are paper-based. Property values rise and fall with changes in economic conditions, interest rates and supply and demand, for example. Sometimes this can be hard to discern because not all property is the same, can be altered, and it is not traded that often. Information on prices can also be hard to come by which disguises changes in value.
Owning property usually comes with some associated costs, such as rates and insurance, and maintenance and management inputs. Property is subject to depreciation of buildings, or "wearing out" over time that will require renovation of some sort, which will cost money.
Property really only becomes an investment when it generates an income. Residential homes should really be regarded as a store of value rather than an investment asset. They require spending on rates, insurance and maintenance, although they provide a return in the sense that it offers shelter that you would otherwise have to pay for.
Residential property is a popular and valid way to invest into property. Although, in general, commercial property investments offer better long-term returns than residential property. Commercial property leases run much longer than residential rental agreements and typically include arrangements to review rents over time. Residential property agreements are much shorter and provide short-term exit clauses for tenants.
It’s much easier to buy and sell residential property. Access to finance through banks is generally easier, meaning that there is a lower barrier to entry than for commercial property. Also, the cost of residential property is generally less than for most commercial properties. Property as an investment requires knowledge of the laws and regulations that govern rental arrangements.
Property can also be owned via listed and unlisted funds which makes it easier to access but which have differing issues attached. These contrasts show us how different assets within one asset class can have divergent risk and return profiles.
The rental income from property, combined with growth in the property value over time should generate a total return greater than bonds, but with investment risk greater than for bonds, but in general less than for shares.
4. Shares
A share is a fractional ownership interest in a company, meaning that owning some of a company’s shares also means owning part of that company. Shares are also known as “equities” or "stocks".
Owning a share gives you access to the profits of the company paid through dividends and the growth (or reduction) in the value of its shares.
The place where shares can be bought and sold is called a share market. These days the "place" has been replaced by "cyber space" with buying and selling being done electronically. Most countries will have one or more share markets. The main New Zealand share market is run by NZX Ltd.
Many companies do not trade their shares through a share market. This applies to most small companies and a relatively few large companies.
Shares can be owned directly by individuals or indirectly through a "pooled" investment fund. These can take the form of Portfolio Investment Entities funds (commonly called PIE funds). PIE funds can in turn be either unlisted or listed on a share market. Share funds can also take the form of index funds (passive investment style) or an Exchange Traded Fund (often referred to as ETFs). There are also companies that invest into listed and/or unlisted shares that are in turn listed on share markets (listed investment companies).
Ownership of a business offers the greatest potential for gain of any of the asset classes discussed so far through growth of the business. But it also comes with the highest risk. Any individual business can fail leaving you with a total loss of the capital you have invested. For this reason, investors should hold a range of shares, preferably through a fund of some sort. The wider the spread of shares the more likely it is you will receive a "market rate of return". While an individual company can fail, markets will always endure.
Gains can be made by trading shares as values rise and fall. This offers significant potential for returns but comes with a risk of creating losses if you get it wrong. Trading in any asset also comes with tax implications which need to be understood beforehand.
5. Alternative Assets
Investors can also hold other forms of investment assets. This asset class tends to catch a lot of other sorts of assets that fall outside the four asset classes mentioned above. This asset class is often called “Alternative Assets”.
Alternative Assets can include "physical" or "hard" commodities such as gold, silver, aluminium, iron or copper. These are things that tend to be mined. There are also "soft" commodities such as oil, wheat, rice, soy, sugar. These things tend to be extracted or grown.
Alternative Assets can also include crypto currency, art, jewellery, stamp collections, antiques, and livestock – just about anything that has a store of value and can be bought and sold!
There are also certain types of investment assets that are based upon other assets. These are called “derivatives”. These are paper assets whose value is derived from the asset upon which they are based. Just about all of the investments in asset classes described above have some sort of derivative investment based on them. There are large wholesale global markets that trade in derivatives.
In general, Alternative Assets can be difficult to get information about, difficult to access and carry the highest degree of risk. Some Alternative Assets do not trade on regulated markets. They really lie in the domain of professional investors.
Building a Portfolio to Manage Risk and Return
History shows that some asset classes perform better than the others at different times, in a way that is very hard to predict. For this reason, portfolio investors should seek to hold a mix of asset classes, each with a range of investments. If put together in the right way, such a portfolio can provide a steadier pattern of returns over time.
How we invest our money in different asset classes depends mostly on our appetite for risk. Lower risk assets tend to be more stable, which makes them a good option for safeguarding wealth in the short-term. Moderate or higher risk assets are better for growing wealth in the longer-term, but that growth potential also comes with a higher risk of losing value for a time due to an economic shock or simple bad luck.
Understanding your appetite for risk is an important step in developing your approach to investing and developing your portfolio in such a way, that it will allow you to remain invested and sleep well at night through the ups and downs in markets that are bound to come your way over time.
Summary
The main asset classes are cash, fixed interest, property, shares and alternative assets. Each asset class is made up of assets that share relatively similar risk/return characteristics. The different asset classes have very different characteristics. This allows investors to mix investments between various asset classes to manage their risk and potential for return over the medium to long-term, in ways that will help them stay invested and achieve their financial goals.
- Cash – Money or short-term bonds that offer low risk and low returns
- Fixed interest – Longer-term assets that offer steady and predictable income with limited variation in the value of the asset and risk of loss
- Property – Real estate that offers returns in the form of rent payments, moderate growth in value but which attracts moderate risk
- Shares – Units of ownership of a company that offer the best prospects for growth, and the potential for dividend income, but which come with greater risk of fluctuation in value
- Alternative Assets – can be a variety of assets with high risk attached to them
The graph below shows the relationship of the asset classes in terms of their expected risks and potential returns.
While not everyone thinks of themselves as an “investor”, nearly all of us do invest. For many, those investments are limited to our KiwiSaver, and perhaps a home. Understanding how asset classes work gives us a better idea of how those investments work and what to expect through owning them.
For example, your KiwiSaver fund will very likely invest in a mix of different assets in different asset classes depending on the type of fund you have selected – often termed a multi sector fund. Choosing the right fund that will balance your appetite for risk with expected returns against your longer-term financial goals is one of the most important investment decisions you can make. The same applies when building a portfolio outside of KiwiSaver.
If you’d like to speak to an adviser about building your investment portfolio, contact us today.
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