By Daniel Archibald | CFA
It is well understood that different types of investments would be expected to perform in a variety of ways: For example, shares do well when the economic outlook is looking rosier; property also follows suit but would have less volatility in price movements; bonds do well when interest rates are falling (usually when economies are struggling). These differences provide the rationale for asset allocation techniques that are based on asset classes. Diversification between different types of investments (that perform in contrasting ways throughout the business cycle), is also used to improve overall portfolio performance.
The most common asset classes for Australian investors are equities, property, bonds, alternatives and cash. Investments that fall into each of these categories would be expected to have similar performance characteristics to each other. Each of these asset classes might also be commonly split as follows:
- Equities
- Australian versus foreign
- Small companies versus large companies
- Value companies versus growth companies
- Property
- Australian versus Foreign
- Residential versus commercial
- Listed versus private
- Bonds
- Government versus corporate
- Short-term versus long-term
- Investment grade versus high yield
- Debt versus collateralised assets
- Alternative assets
- Hedge fund strategy versus real assets
- Cash
- At call deposit versus term deposit
The idea behind asset class segregation is to help make the decision-making process more efficient or easier. Rather than deciding between millions of different types of investments, if many of those investments act in the same way, it can be simpler to decide between such asset classes instead.
Another way in which investments can be segregated is according to their historical sensitivity to investment risk factors. However, instead of making a subjective call on whether or not a company is domestic or small or growth, statistical analysis can be used to objectively determine the relationship between a company's equity and identified factors. There are two common types of factors, macroeconomic factors and style factors. The former can be applied to most all investments and is used more and more as a replacement for asset class-based investing, whereas the latter is generally reserved for the equities and can be used with either an asset class-based investing program or a macroeconomic factor-based form of investing.
Macroeconomic factors include the following:
- Interest rates/duration - i.e. how sensitive is the asset's returns to changes in real interest rates. Bonds and other yielding assets (property, infrastructure, etc) tend to be more sensitive to interest rate changes
- Inflation - i.e. how sensitive is the asset's returns to inflation. Inflation changes can influence the price of assets, especially if earnings/income does not change with prices
- Credit - i.e. how sensitive is the asset's returns to the risk of default. Corporate bonds are particular sensitive to changes in credit risk
- Economic growth - i.e. how sensitive is the asset's returns to economic activity. Equities are the sensitive to changes in economic growth prospects
- Liquidity - i.e. how sensitive is the asset's returns to the risk of illiquidity. All asset classes can have illiquidity issues, however, unlisted assets and alternative assets tend to be most sensitive to changes in liquidity
- Geographical/emerging markets - i.e. how sensitive is the asset's returns to geopolitical risks. All asset classes are likely to be sensitive to political and sovereign risks
Style factors, which have similarities to some of the equity class splits mentioned above include the following:
- Market - i.e. how sensitive is the stock's returns to the market return. The market return is likely the best barometer to the overall sensitivity of equities to the macroeconomic factors mentioned above.
- Value - i.e. how sensitive is the stock's returns to the level of the company's relative pricing. This is generally determined by the ratio of a company's price to the book value of its assets. Value stocks have shown an outperformance over non-value ('growth') stocks for large portions of history, though the recent bull market has shown the opposite
- Size - i.e. how sensitive is the stock's returns to the size of the company. Smaller company stocks have also shown outperformance over larger companies for much of the market history
- Momentum - i.e. how sensitive is the stock's returns to the level of the company's price momentum. This is a short-term factor that highlights the tendency for prices to continue moving in the current trajectory for longer than expected
- Volatility - i.e. how sensitive is the stock's returns to the level of price volatility. Lower volatility stocks have also tended to outperform.
- Quality - i.e. how sensitive is the stock's returns to the level of the company's earnings quality. This is generally measured by stability and sustainability of a company's revenues and profits.
- Carry - i.e. how sensitive is the stock's returns to the level of the company's cost of carry. Companies that pay higher dividends have also tended to have produced higher performance over time.
Analysis is conducted to forecast how each factor is likely to perform. An investment's exposure to these factors can then be used to determine its likely performance and its allocation within a portfolio. While most investors still utilise the asset class-based system of investing it is still important to understand an asset class' sensitivity to macroeconomic factors.