Asset Allocation: Asset Classes

In this article, I would like to quickly introduce the various asset classes and how they might fit into your portfolio. This is not meant to be an exhaustive list but just to give some ideas when building your portfolio.

Towards the end of each section, I would provide some example ETFs of each class.

This is a continuation from my previous article “Portfolio Building Basics: Asset Allocation“. So if you are unfamiliar with asset allocation, I would recommend giving it a read.

To quickly recap, there are 4 main asset classes

  1. Bonds
  2. Stocks
  3. Real Estate Investment Trusts (REITs)
  4. Commodities

Bonds

Bonds are debt securities issued by government, municipals, corporations or other organizations sold to investors

Basically, when you buy a bond, you are lending money for a time period to the bond issuer and usually you receive coupons (interest) as payments for it. When held to maturity, you will get back your principal.

There are also types of bonds that do not offer coupons (discount bonds) and bonds that will not pay back your principal (perpetual bonds).

For the most basic portfolio, a combination of bonds and stocks will do just fine. In my earlier article on asset allocation I showed different combinations of bonds and stocks to adjust your risk.

In general, bonds are more secure than stocks and provide stability to your portfolio.

However, there are different types of bonds that you might need to take note of.

Low Yield vs High Yield Bonds

Credit ratings by ratings agencies give us a sense of credit worthiness of the bond issuer which affects the bond’s yield.

Low Yield Bonds

  • Investment grade
  • High credit rating e.g. AAA
  • Low default risk (safe)
  • High quality firms, US treasuries, developed countries government bonds
  • Added to portfolio for stability

High Yield Bonds

  • Junk bonds
  • Low credit rating e.g. BB
  • High default risk (risky)
  • Low quality firms, emerging market government bonds
  • Not recommended for stability. Should be treated like stocks

Short-Term vs Long-Term Bonds

Bonds can have varying maturity from a few months to several decades. The longer the maturity, the higher the yield of the bond.

In addition, bond prices are correlated to interest rates. When interest rates falls, bond prices increase. Long term bonds are more sensitive to interest rate changes and will tend to fluctuate more – leading to more volatility.

Short Term Bonds

  • Shorter maturity
  • Lower yield
  • Lower price fluctuations
  • Less volatile

Long Term Bonds

  • Longer maturity
  • Higher yield
  • Higher price fluctuations
  • More volatile
Examples of bond ETFs. This is not a recommendation

Stocks

Within stocks, there are also different sub-classes which are including in portfolios. I will not be able to cover all but just listing the few most common ones.

Domestic vs International

As a DIY investor, myself included, we tend to start with just holding stocks from our home country. This is because we know the businesses in our country best and we are comfortable with familiarity.

However, there are more benefits from investing in international stocks compared to just investing in your own country.

Domestic

  • Subjected to economic and geopolitical risk of your home country
  • Lower expected returns if your home country underperforms
  • Tax efficiency – not subjected to foreign withholding taxes
  • No currency risk
  • Familiarity

International

  • Diversification across economic and geopolitical risks
  • Higher expected returns if your home country underperforms
  • Higher taxes – subjected to foreign withholding taxes and/or estate taxes
  • Currency risk
  • Less familiarity
Examples of domestic and international ETFs

Developed vs Emerging Markets

Emerging markets stocks tend to be riskier than developed markets stocks but also have a high expected return.

Developed Markets

  • Less risky
  • Higher valuations – lower expected returns
  • Liquid
  • Easily accessible
  • ETFs tend to have lower costs
  • Lower tracking error

Emerging Markets

  • More risky
  • Lower valuation – higher expected returns
  • Diversification benefit – less correlated with developed markets
  • More illiquid and less assessable compare to developed markets
  • ETFs tend to have higher costs due to previous point
  • Higher tracking error due to previous two points

However, in the recent times, emerging markets have not been performing as well as the developed markets.

Another point to highlight is that in the event of a crisis or a market crash, the correlation between emerging markets and developed markets increases thus eliminating any diversification benefit.

Examples of developed and emerging market ETFs

Factors

In 1992, Fama and French published a paper which introduces a model of three factors to explain stock returns. The two factors other than market risk are size and value

Since then, they went on to publish an updated 5-factor model and there have been many more factors discovered by other researchers. But that will be a topic for another post.

The point here is each factor is an independent risk which is not correlated to each other. Hence, adding factors into your portfolio will provide diversification benefits.

Small Cap vs Large Cap

Small cap refers to companies with small market capitalization. Its definition varies but according to investopedia typically it is market capitalization between 300 million to 2 billion USD.

The typical indices that we see like the S&P 500, FTSE 100, HSI or STI are large cap indices – meaning it only tracks the largest companies in the market. So you might be missing out in small caps in your portfolio if you stick with those indices.

Total market index ETF will solve this issue because those include all large, mid and small cap stocks.

Small Cap

  • More risky
  • Higher expected returns
  • Less liquidity
  • ETF costs higher due to liqudity
  • Higher tracking error

Large Cap

  • Less risky
  • Lower expected returns
  • High liquidity
  • ETF costs lower
  • Lower tracking error

Value vs Growth

Another factor is value which are stocks discounted relative to their fundamental value

The opposite of value stocks is growth stocks which have higher price to fundamental value. These are usually companies with fast earnings growth, typical of the tech industry. The FAANG are growth stocks.

Value

  • Priced at a discount relative to their fundamental value
  • Higher expected returns
  • Stable or slow earnings growth

Growth

  • Priced higher relative to their fundamental value
  • Lower expected returns
  • High earnings growth

Recently growth stocks have been beating value stocks for the past decade.

Examples of value and small ETFs
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REITs

Real Estate Investment Trust is a company that owns or operates real estates which generate income.

This is a very popular kind of investment which provides high dividend yield with potential of capital appreciation.

Pros

  • REITs generate income like bonds or dividend paying stocks
  • REITs has capital appreciation potential like stocks
  • Diversification to other kinds of assets
  • More liquid than owning a property

Cons

  • Subjected to property market risk
  • High management and transaction fees
Examples of REIT ETFs

Commodities – Gold

There are other kinds of commodities but the most commonly held is gold. Gold is often a safe haven and is a hedge against inflation.

  • Store of value
  • Hedge against inflation
  • Diversification
  • Safe haven
Examples of gold ETFs

ETFs have made it much easier to own gold. Other ways of investing in gold is by investing in gold mining companies or buying physical gold.

Conclusion

Adding more uncorrelated asset classes provides the benefits of diversification – the free lunch in investing.

For the final part of this series on asset allocation, I will discuss about portfolio rebalancing and provide some sample portfolios.

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Author: Fatty's Finance

Finance is like health. It becomes an issue if it is not well maintained. I want to help you get back in shape!

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