Asset allocation is central to creating a portfolio. The investor has to decide how much, if any, to have in shares, or bonds, or property. Those big picture decisions usually have the biggest impact on how much money you make or lose. At Charles Stanley we spend a lot of time and effort trying to understand what moves the prices and returns of the major asset classes, to come to a view of how much of them we should recommend for a portfolio. We also need to understand how much risk there is, as some of these assets can from time to time go down in a hurry as well as offering scope to earn you a return.
The two main types of financial assets investors consider for their savings are bonds and shares. Many other financial investments are variants of those. A bond is a loan by a group of bondholders to a government, company or project. The borrower agrees to pay interest on a regular basis, and usually agrees to repay the money at a stated future date. The bond is often fixed interest, meaning the lender gets the same amount of interest at regular intervals for all the time he owns the bond. There are some bonds where the return is variable. Index-linked bonds, for example, increase the interest payments as inflation increases. The bond holder usually has a claim on the assets of the business or the particular asset he has lent to, should the borrower be unable to keep making the payments.
A share is a participation in the assets and success of a venture or company. The share is not normally repayable, but is permanent capital. There is no fixed or guaranteed income paid on the share. Dividends vary depending on the success of the venture. The shareholder has no claim on particular assets, and is the last person in the queue of creditors in the event of bankruptcy. Most shares are limited liability, meaning the shareholder is only at risk for what he has put into the company. He profits from any gains or income the company earns to the extent of his share, whether the money is paid out to him or remains on the balance sheet of the company. If the company keeps the profits it can reinvest to make more in the future.
There are hybrids between bonds and shares, including convertibles. There a person buys a bond but that gives him an option to convert it into a share at a later date on specified terms. There are a few bonds with no repayment dates, and some bonds with variable interest. There are preference shares which gives their holders priority over general shareholders in a bankruptcy, but limits their entitlements to the gains of the business and usually comes without a vote on how the company is run.
Private equity is usually seen as a separate asset class. Whilst this entails making share and bond type investments in a range of companies, it is different from traded shares for a variety of reasons. The underlying businesses do not normally have quoted shares, so a private equity investment is illiquid. You cannot sell it when you like on a share market. There is normally some agreement to be involved for a minimum period of years, and either the private equity investor or the private equity fund that does it for the investor is active in the companies they are assisting. This is patient capital, where investors hope for higher returns than on quoted shares to compensate for the higher risks they are often running and for the lock in to the investment. The companies may be smaller and in their early stages of development, or they may be older and larger needing some kind of management turn around.
Property is also a different asset class. If you buy a commercial building you enjoy a rental income which has some of the characteristics of a bond income, and you run an equity type risk as you lose your income if the tenancy ends until you can find a new tenant. You are liable for repairs and maintenance, rates and other taxes. Unlike shares, your risks as owner are not limited to the money you used to buy the building. Unlike bondholders, your income goes up on a favourable rent review but can diminish or disappear if there are tenancy problems. This is why property is seen as a different asset class from bonds or shares.
Commodities too are normally regarded as a different class of asset. Investors can hold commodities directly in store, or they can buy financial instruments which represent commodities someone else is storing. They are different from shares and bonds, as they produce no income and entail substantial holdings costs from warehousing to insurance. The aim of the buyer is to enjoy capital gains if the prices go up. They have a bit of a reputation for danger because there have been cases of big swings in price in the past, leading to financial difficulties for some involved in commodity trading.
Some argue that global infrastructure is a different asset class. They suggest that a range of investments in communications networks, power generation, roads or health facilities have unique characteristics that justify a separate category. They often entail a regulated monopoly position, or a long term contract from a government. They have more stable revenues than many businesses because they normally supply services which people have to buy, as they are basics like water and electricity. The investment is usually long term.
In practice much infrastructure investment is share investing by another name, taking stakes in utility or transport companies. Some is bond investing, providing loans to individual projects and facilities. Some is more like private equity, taking patient large stakes in long term projects to try to get a superior return from the revenues of that project. Maybe there is a specialist asset class called infrastructure that has been designed by those who run specialist investment funds. It is likely, however, to have either more bond or more private equity or more quoted equity characteristics depending on its composition.
The above article was first published by Charles Stanley on 30th January 2018