By Anirudha Taparia, Executive Director, IIFL Investment Managers
This guidance can come from wealth managers who not only understand their client’s requirements but can also help them make more informed investment choices
There is a lot of financial literature that waxes eloquent about the need for portfolio diversification. Indeed, by diversifying your portfolio across multiple asset classes, you can mitigate the impact of extreme movements on your portfolio, thereby enhancing its return potential. Different asset classes react differently to certain financial and economic events. For example, in a rising interest rate scenario fixed income products might benefit from a likely hike in interest rates on deposits and higher coupon rates on bonds. However, equity products might under perform in such an environment as rising rates might increase the cost of capital for firms and consequently have an adverse impact on corporate performance. It is for this reason that most financial advisors and wealth managers will advise investors to diversify their portfolio across multiple asset classes so that the investor’s portfolio is well balanced. However, in order to achieve optimal diversification, it is important to not only be aware of the different asset classes but also understand how each asset class can help you mitigate portfolio risks and achieve portfolio goals.
What is an Asset Class?
An asset class is a group of similar investments. Different classes, or types, of investment assets – such as fixed income investments – are grouped together based on having a similar financial structure, and because they are typically traded in the same financial markets and subject to the same rules and regulations. Broadly most investments are divided into four or five asset classes. These include equities, fixed income, cash or cash equivalents, real estate and commodities.
Sophisticated Investment products that go beyond cookie cutter solutions
When it comes to investment products, investors today are spoilt for choice. A plethora of products holding different levels of risk and designed to deliver varied returns are now available to investors. However, the lines between different investment products sometimes blur making it difficult to bucket an investment into any particular asset class. The onus to educate the clients about different investments and asset classes falls upon wealth managers.
There are many additional factors that are at play when it comes to classifying asset classes. An investor who is investing in stock market futures can either classify this as an equity investment or classify it as a futures investment. Depending on the kind of strategies being used he could also classify it as an alternative investment. Investment in gold and silver leads to a similar quandary. Since gold and silver are most frequently traded in the form of derivatives, should they be classified as commodities or financial derivatives? If you invest in a real estate investment trust (REIT), should that be considered an investment in tangible assets or as an equity investment since REITs are exchange-traded securities?
An expansion in available investments creates further complications. Exchange-traded funds (ETFs), for example, are traded like stocks on equity exchanges, but ETFs can be structured to comprise stocks, bonds, commodities etc. An ETF that offers exposure to the gold market may be partly composed of investments in physical gold bullion and partly composed of stock shares of gold mining companies. In addition to basic types, assets may also be categorised by location. Domestic markets, international investments, emerging markets, all constitute different asset classes and could have a risk/return profile which is different from the previously mentioned broad asset classes. There are additional asset classes, such as artwork, various other collectibles, peer to peer lending, hedge funds, Bitcoin and other alternative currencies that represent some other asset classes that are a bit more off the beaten path. Classifying these investments in any particular asset class can sometimes be confusing. If one is not able to aptly classify the investment in a particular asset class, then achieving portfolio diversification becomes all the more challenging.
Help is at hand
As is evident, it is not enough to know and understand just the basic categories of asset classes. A fundamental understanding of asset classes can help investors recognise the nature of the various investment options available to them and consequently guide them in making optimal portfolio decisions. However, instead of just merely scratching the surface, investors should better understand the risk/return profile of sophisticated investment products. This guidance can come from wealth managers who not only understand their client’s requirements but can also help them make more informed investment choices.