Our Asset Classes
As asset is a good candidate for our investment portfolio if it is:
Likely to deliver a competitive risk-adjusted return
Offers a unique correlation to other assets
Available in a liquid and transparent format
There is no single best answer for how many asset classes should be included in a portfolio, investors need to find a balance between assets that can deliver a unique investment stream while not over complicating the portfolio. We want to have just enough assets to effectively reach our targeted risk-adjusted return. Below we break out our asset classes and rationale for inclusion.
Cash and Short-Term Bonds
Cash is the most risk-averse asset, although it is not without risk. We include bank deposits, money market funds and short-maturity AAA government bonds in this category. While most people consider these "risk-free" assets, money market funds do have a small amount of credit risk (i.e. breaking the buck) and the return of your principal is not guaranteed. Cash and short term government bond yields may not be able to keep up with inflation, as is happening now in the US and Europe, and your purchasing power will actually decrease - a negative real return.
We define Cash as a fixed income investment with less than 1 year to maturity and Short Term Bonds as debt with a maturity greater than 1 year and less than 3 years.
Developed Government Bonds
Developed Government Bonds are fixed income investments with maturities greater than 3 years and credit rating of BBB- or better. In general, these bonds pay coupons at a fixed rate, however we include Treasury Inflation Protected Securities (which are indexed to inflation) as well.
Bonds have historically exhibited a negative average correlation to equities, but this relationship is not exact and can break down at times. This often occurs when inflation turns out to be much higher or lower than the market anticipated. Bonds also experience less volatility than equities and other asset classes.
Investment Grade Bonds
Investment Grade Bonds are fixed income investments with maturities greater than 1 year issued by companies with a BBB- or higher credit rating.
Returns are driven by interest rates and the level and change in the amount of additional yield, or spread required to compensate investors for the risk of default. The changes in yield spreads between investment grade and government bonds, reflecting market expectations about the probability of future defaults that drive returns. Credit quality of companies generally improves and spreads tend to tighten as the economy improves, so Investment Grade Bonds may produce better returns than Developed Government Bonds when interest rates are increasing and government bonds are performing poorly.
High Yield and Emerging Market Bonds
High Yield Bonds are fixed income investments issued by companies with low credit ratings. Emerging Market Bonds are issued by sovereign and government related agencies. The bonds may issued in major currencies (US Dollar, Euro, etc.) or in the local currency. Similar to Investment Grade Bonds the factors driving returns are interest rates, defaults and yield spread. However, the magnitude of contribution by each factor is different than Investment Grade Bonds. Emerging Market Bonds issued in local currencies offer another potential source of return - the appreciation or depreciation of the currency relative to the US Dollar.
Developed Market Equities
Developed Market Equities consists of stock issued by companies located in the developed countries of North America, Europe and the Pacific. The United States represents approximately 50% of the market capitalization of developed world equities. Equities are driven by a variety of factors including: market valuations, profit margins, the business cycle and investor psychology.
Emerging Market Equities
Emerging Market Equities are stocks issued by companies located in emerging markets. Emerging Market Equities have been significantly more risky over the past 20 years than Developed Market Equities. However, these countries are maturing rapidly; emerging country stock markets have been accounting for a larger share of total global equity market cap - from about 4% in 2003 to 13% today.
Frontier Market Equities
Many frontier markets are still in the process of developing and improving their infrastructure, to support their growing populations, and this creates many opportunities for domestic and foreign investment, which vary greatly from one market to another.In addition, frontier markets offer an additional layer of diversification, because they often have low correlations with each other. This is a product of their diversity, as they are driven by many different and often localized factors, and also frequently operate in different currencies. As a result of this, frontier markets have historically been less volatile than mainstream emerging markets, as the next chart demonstrates.
For many investors Real Estate is often their largest holding outside of their investment portfolio. Real Estate generally accessed through the public markets by Real Estate Investment Trusts (REITs). REITs provide a tax-efficient, liquid way to invest in commercial and residential propety. REITs also allow investors to overcome high management and transaction costs, and avoid concentration risk.
Commodities are physical assets like gold, oil or corn. An allocation to commodities can prove helpful when inflation turns out to be substantially higher than investors had expected. In this type of environment bonds and stock tend to decline and inflation adjusted yield on cash are often negative, however commodity prices are likely to rise.
We utilize active managers within the currency allocation to capture movements in the exchange rates of major currencies. Currency markets are extremely liquid, even during times of crisis. Historically, currency managers have exhibited very low correlation to other asset classes.
Alternative Strategies seek to generate profits by actively taking long and short positions in a wide range of markets. Investors can access Alternative Strategies through ETFs, mutual funds or separate accounts. Alternative managers tap into a range of sources of investment returns. Some are fundamentally based while others are systematically driven. Some strategies are considered market neutral, that is the directional movement of the market does not impact the returns of the strategy; an example of a market neutral strategy is merger arbitrage.The successful inclusion of alternative strategies within a portfolio depends on a rigorous and continuing selection and monitoring process.