Understanding Investment Asset Classes
The pluralism of investment asset classes requires investors to
understand their characteristics and roles in multi-asset portfolios
Lustig, author of The
Investment Assets Handbook
In the last two decades of the
twentieth century investors enjoyed an
impressive bull run in both equities and bonds. Multi-asset portfolios
then were really only bi-asset portfolios, mainly invested in these two
major investment asset classes. Why would anyone want to complicate it
by adding other assets when those two generated handsome returns while
reducing risk through diversification? The investing world was simple
The dawn of the twenty-first century brought an abrupt end to these
simple days. When the bursting of the technology bubble struck the
financial world in 2000, and then again when the 2008 global financial
crisis hit markets, the quest for new investment asset classes woke up
from its dormant state. Not only did equities disappoint investors, but
also the correlation among some assets jumped upwards and the merits of
diversification were questioned. Investors sought new engines to
enhance returns, new diversifiers to dampen volatility and new types of
investment assets to mitigate
portfolios’ downside risk. Multi-asset
investing, as we know it today, was born.
Today, investors have an ample choice
among a long list of investment
asset classes. Globalisation, technological advantages and financial
innovation mean that never before were investors able to cast such a
wide net to choose assets for their portfolios. Truly global equities,
both public and private; government bonds from across developed and
developing countries; corporate bonds issued by investment grade and
speculative entities; commodities, ranging from metals in Australia to
timber in Canada and everything in between; real estate in London,
in New York, catastrophe bonds in Tokyo; and farmland in Africa. The
menu can be mind-boggling, and this is only but a sample.
With such a wide spectrum on offer how can investors make sense of this
sometimes-confusing choice? What framework can investors use to
understand the characteristics and behaviour, and most importantly, the
role of each investment asset class within multi-asset portfolios?
The characteristics of investment
An intuitive way to think about the
characteristics of investment asset
classes and understand their behaviour is analysing the risk factors to
which assets are exposed. Risk factors are the fundamental building
blocks that drive the majority of return and risk of investment assets.
Each asset is a bundled exposure to a number of risk factors.
Understanding the risk factors allows investors to form a familiarity
with the asset and a feeling of how
it should behave under different
I identify 10 risk factors, as well as a special, residual one. This is
one proposed list of factors – it is certainly not exhaustive, but it
should explain the lion’s share of the performance of most investment
rate. The prevailing interest rates in the market,
excluding inflation. Central banks control short-term interest rates,
while market forces set long-term rates. Real rate is one of the
variables in the discount factor used to calculate the present value of
future cash flows that assets generate. Hence, real rate is important
in valuing any asset.
The price of government bonds with negligible default risk is a
function of real rate and inflation as they generate a stream of
predictable cash flows. The price of inflation-linked bonds is adjusted
for inflation. So their value is a function of real rates. Higher real
rates lead to lower price of bonds and vice versa lower real rates lead
to higher price of bonds. Interest rate risk reflects change in real
rate. Longer maturity bonds have higher interest rate risk than shorter
rate. The rate of inflation in the market. Inflation is
mainly determined by the supply of money and demand for products and
services. Together, real rate and inflation rate make the nominal rate.
Inflation rate affects the price of most assets whose cash flows are
generated over a long time period as inflation can erode their
purchasing power. Inflation risk reflects changes in inflation rate.
Often, it is not actual real rate and
inflation rate that matter, but
rather investors’ expectations of real rate and inflation rate. This is
where psychology and sentiment take a centre stage. If investors’
perception is that real rate and inflation rate are to drop, they will
buy bonds, bidding their price up and yield down. At the end of the
day, forces of supply and demand set the prices of investment assets.
These forces can be driven by fundamental risk factors, but can also be
by how investors view the risk factors.
spread. The difference between interest rate or yield of
investment grade bonds and government bonds. The yield of investment
grade bonds is the nominal yield of the reference government bonds plus
the credit spread. It reflects the credit risk or risk of default of
bonds compared to that of comparable government bonds. High credit risk
requires a wide credit spread to compensate investors for the risk and
convince them to lend money to the issuer. The price of investment
grade corporate bonds is a function of real rate, inflation rate and
Credit spread is linked to the commercial fortunes of each issuer so it
is influenced by the state of the general economy and the idiosyncratic
state of the issuer. Therefore, credit spread is similar to equity
risk, which is also influenced by similar variables.
yield spread. The difference between interest rate of
below investment grade or speculative bonds and government bonds. It
reflects the higher risk of default of junk bonds compared to that of
comparable government bonds. High yield spread is much more sensitive
to the commercial fortunes of the economy and each issuer than credit
spread. Therefore, high yield bonds can behave more like equities than
like investment grade bonds.
market spread. The difference between interest rate of
bonds issued in emerging economies compared to comparable government
bonds issued in developed economies. It reflects the risk of default of
issuers in emerging economies, as well as different real rate and
The first five risk factors explain the majority of performance of
fixed income instruments.
growth. The economic growth rate of developed economies.
It affects the prices of equities in developed markets since equity
price reflects the expectations of investors about the future prospects
of each issuing company and the general economy. Equity risk reflects
changes in developed growth rate.
While developed growth is positively linked to the price of equities,
it is negatively linked to the price of government bonds. When the
economy expands, real rate is expected to rise, as does inflation rate.
This has a negative impact on the price of government bonds. For spread
products, increasing developed growth can narrow the spread over
government bonds while putting negative pressure on the reference
government bonds. The direction of price is determined by which of
these two opposite forces is stronger.
growth. The economic growth rate of developing economies.
It affects the prices of equities in emerging markets. While emerging
market equity price is a function of emerging growth, it is also a
function of developed growth, explaining the sometimes-high correlation
between emerging and developed equities. This link has become stronger
over the last two decades as financial markets have become more
The factor that affects the prices of small capitalisation
equities. These are normally riskier than their large cap peers.
However, small and medium size risks should earn a rewarded for
The price of commodities.
It does not only affect the prices of
commodities as a separate investment asset class, but also the
performance of equities since commodities are an important input in the
operations of companies and sometimes an output of companies.
The fluctuations in exchange rates between currencies. Every foreign
investment denominated in a foreign
currency comes with a currency
risk. Currency risk can have a large impact on performance when
measured in the base currency of the investor.
risk factor. A residual risk that is not captured by the
other 10 risk factors. The performance of some investment asset
classes, such as real estate, private equity and art cannot be
explained only by the other 10 factors. These assets have something
special that explains their performance in addition to the other
factors. This special risk factor is what makes alternative investments
unique since they bring something new to the plate, adding a return
that is not covered by those of the traditional investment asset
classes of equities and bonds.
The 10 factors and the special one explain the performance of most
investment asset classes. By understanding the factors and how each
asset is exposed to them, investors can truly understand the
characteristics, behaviour and correlations of investment asset classes.
Investors should remember three lessons
from risk factor analysis.
First, investment asset classes can have exposure to common risk
factors. For example both developed equities and investment grade
corporate bonds share an exposure to developed growth. This explains
why they are correlated. Investors should ensure that their portfolios
are diversified across uncorrelated risk factors to reduce risk, rather
than across investment asset classes that might be correlated.
Second, the exposure of investment assets to risk factors changes – it
is dynamic. Investors should update the risk factor analysis regularly
to capture the dynamism in risk exposure.
Thirdly and finally, the market compensates risk factors by risk
premiums. Equity risk premium, maturity risk premium and credit risk
premium are the traditional ones. Size, value, momentum, quality,
low-beta and others are the non-traditional ones. Investors should
harvest risk premiums and dynamically expose their portfolios to risk
factors that they believe should attract the highest risk premium
during different states of the economy.
The modern way to think about
investing is to focus on the outcome that
investors seek. The goal of investing is not to beat or match some
is at best weakly linked to the investment objectives of
investors. Rather, the goal should be strongly linked to investors’
needs. I identify four investment outcomes: (1) growth; (2) income; (3)
inflation; and (4) liabilities.
Growth is, as its name hints, growing the value of investment assets.
For example, when an individual saves for retirement the goal could be
growing the value of the pension pot by an average of 5% per year.
Income, the second outcome, is generating cash flows from investment
assets. For example, when the individual reaches retirement the goal
could be to generate a yield of 4% from the pension pot. The growth and
income outcomes may be combined, as our individual would like to
preserve the capital of the pension pot, while spending the income, so
the portfolio needs to grow so it can keep generating income for years.
Inflation, the third outcome, is maintaining the purchasing power of
investment assets over time to battle the erosion from inflation. This
is especially important over the long term. Growth can be expressed as
real growth so it includes the inflation outcome plus growth above the
rate of inflation. Our pensioner may live for many years after
retirement so the purchasing power of the pension pot should at least
keep pace with inflation.
Finally, liabilities outcome is
keeping the value of investment assets
in line with the value of liabilities. For example, a defined benefit
pension scheme has a stream of cash flows that it needs to pay to its
members over their lives. Changes in interest rates and inflation can
change the value of those liabilities. The scheme can hold some assets
whose value should change to match the value of the liabilities to
of mismatch between asset and liabilities.
These four outcomes encompass the reasons for holding investment
assets. With these outcomes in mind, investors can think about the
characteristics of investment assets and map their roles in the context
of how they match the desired investing outcomes.
But it is not only the final outcome that matters to investors, but
also the journey. The journey can represent the volatility of the
voyage. Volatility of returns is one of the most common measures of
risk. The journey can also represent whether the outcome is
delivered on time or at all. The outcome should be achieved during the
investor’s investment horizon; otherwise, it is a failure of delivery
or a permanent loss.
This is the true risk of investing.
1: Investment outcomes and characteristics of investment assets
Characteristics of investment assets
Equities, high yield bonds, emerging market
Government bonds, investment grade corporate
bonds, real estate
Inflation-linked bonds, commodities, real
Government bonds, swaps
Each asset that you own should have a
role. You own a car for mobility,
you own a house for shelter and you own a television for entertainment.
Similarly, each investment asset that you hold in your portfolio should
fulfil a legitimate investment role.
The roles of investment assets should be either to achieve the
investment outcome and/or to improve the journey to achieve the
investment outcome. I identify seven legitimate investment roles for
investment assets. The first four are aligned with investment outcomes:
(1) growth; (2) income; (3) inflation hedging; and (4) hedging
liabilities. The last three roles are to improve the journey: (5)
diversification; (6) hedging risks; and (7) protecting.
is generation of capital appreciation or returns. Equities,
example, come with the hope of appreciation of their value over time
and they are the classic growth engines of many portfolios. Within the
fixed income space the growth assets are high yield bonds and emerging
market debt. These assets can be used as equity-substitutes as they can
have potential for capital appreciation and yields that can contribute
to total returns. Normally, these assets have lower upside and downside
risk compared with those of equities.
is yield or regular generation of cash flows for distribution. The
classic yielding assets are fixed income instruments, such as
government bonds and corporate bonds. Cash can also deliver yield.
However, in the current low-yield environment cash hardly provides any
decent yield. In this environment, investors are pushed to riskier
assets with higher yields than cash to satisfy their hunger for income.
Real estate and Real Estate Investment Trusts (REITs) are a source of
rental income. Many multi-asset income solutions rely on four building
blocks to provide yield: investment grade and high yield corporate
bonds, emerging market debt, REITs and equities for their dividend
hedging is the preservation of purchasing power over time
or generating positive returns when inflation unexpectedly rises. The
classic inflation hedging assets are inflation-linked bonds,
commodities, real estate and infrastructure. Inflation-linked bonds are
designed to adjust their coupons and principal to changes in inflation.
The prices of commodities should be linked to inflation and so are the
prices of properties and infrastructure assets.
liabilities is immunising against the effect of
liabilities. Normally, long-term bonds with a matching maturity to that
of the liabilities or derivatives, such as interest rate and inflation
swaps, are used to hedge liabilities. Many investors divide their
portfolio between growth assets, whose role is growth, and matching
assets, whose role is hedging liabilities.
benefits come with low
correlation with other assets.
investors seek assets with low correlation with equities, which make up
the bulk of most portfolios. Diversification reduces the overall risk
of the portfolio. Classic diversifying assets are government bonds,
which should have low correlation with equities since risk factors that
affect equities favourably should affect government bonds negatively,
and vice versa. For example, strong economic growth should lift the
value of equities but put downward pressure on bonds since interest
rates and inflation are expected to rise.
Other diversifying assets are alternative investments, such as
commodities, real estate and some hedge funds, in particular market
neutral. The performance of these assets is driven by special risk
factors different than those driving the returns of equities. Unique
risk factors increase the probability of lower correlation.
risks is removing the exposure to a risk without incurring
the transaction costs and time to sell it. Most assets in this category
are derivatives that are used to take the opposite position to the risk
or exposure that needs to be hedged.
is generating positive returns when risk asset fall to offset some of
the negative effect or generating positive returns during flights to
bonds, the US dollar and long volatility are examples of protective
Classification of investment assets
Considering the outcome and the
journey, one classification of
investment assets is a separation into risk and conservative assets.
Risk assets come with volatility of returns, a potential for a severe
drop in value and risk of a permanent loss. This does not sound very
good – it sounds risky. But risk assets also come with a reward.
Financial markets incentivise investors to assume investment risks, as
higher risks should attract higher returns. So the main characteristic
of risk assets is the generation of growth.
The growth can be volatile. But for those who can stomach fluctuations
in an assets’ price, higher returns can be the reward. However, the
returns might be negative. Typical risk assets include public and
private equities, high yield bonds, emerging markets debt, and
One feature these assets have in common is potential
returns with volatile prices.
Conservative or safe-haven assets come with lower volatility of returns
compared to risk assets; the potential of severe drop in value is
lower, as well as the risk of permanent loss. The main features of
conservative assets are that they tend to maintain their value in
nominal terms (mind you, nominal does not mean real or after inflation)
and they normally generate a steady stream of cash flows. So the main
characteristic of conservative assets is the generation of income.
The income is normally steady, notwithstanding
default. This does not mean that conservative assets
cannot generate growth or capital appreciation or depreciation. But
their growth is not as high or low as that of risk assets. Conservative
assets include government bonds, investment grade corporate bonds, and
The financial world is dynamic – nothing is stationary. Conservative
assets can change their fundamental characteristics and turn into risk
assets. For example, the investment grade bonds issued by Lehman
Brothers lost all their value in 2008 and the safe-haven status of
sovereign bonds issued by the government of Greece turned into junk in
2011. Investors need to monitor the dynamic
characteristics of assets
and classify them according to current conditions.
The separation between outcomes and risk and conservative assets is not
always clear-cut. Equities, for example, generate growth, as well as
income in the form of dividend yields. Investors should not rigidly
classify an asset into a bucket without considering its characteristics
across the four outcomes.
Another classification of investment assets is that of real assets.
This is not the separation between tangible real assets and intangible
financial assets that source their value from contractual terms. Here,
real assets are those whose value should keep up with inflation over
time. The values and returns of inflation-linked bonds, commodities,
real estate and infrastructure should fair favourably in inflationary
regimes. So the main characteristic of real assets is hedging inflation.
Finally, when liabilities are thrown into the mix of asset management,
the characteristics of assets should be evaluated relative to those of
the liabilities. Here investors should look for matching assets. When
liabilities are spread over the next 10 years, for instance, government
bonds with a matching maturity of 10 years can be conservative assets.
Their value should match that of the liabilities when interest rates
fluctuate. Cash is a risk asset when considering liabilities since its
value will not match that of the long-term liabilities.
The three main risks of liabilities
that investors normally seek to
hedge are interest rate, credit
and inflation. So assets with matching
but opposing risk to those of liabilities have the properties to hedge
liabilities. Here the characteristics of the assets are defined by the
The proposed framework is therefore to think about the characteristics
of each investment asset relative to the outcomes that investors are
seeking. These characteristics are dynamic and specific to the
individual circumstances of each investor and conditions.
Lustig is Head of Multi-Asset Investments UK at AXA
Investment Managers and author of Multi-Asset
Investing and The
Investment Assets Handbook, both published by Harriman
Investment Assets Handbook: A Definitive Practical Guide
to Asset Classes
Publisher: Harriman House
Published: 02 December 2014