Types of Investments
Modern Portfolio Theory (MPT) seeks to maximize return and minimize risk by carefully diversifying among different asset classes, focusing on the portfolio as a whole. The theory was first introduced by the Nobel Prize laureate Dr. Harry Markowitz in 1952. Prior to MPT, investors focused on evaluating the risk/return characteristics of individual securities in constructing their portfolios, which usually steered portfolio allocation toward being highly concentrated, creating unnecessary risk to investors. To avoid this, Markowitz introduced the idea of diversification among a group of non-correlated asset classes. This, at least in theory, produces a portfolio with lower risk than most individual securities bear on a standalone basis. Put simply, when one asset class drops in value, a broad diversification into other classes should help hold more steadily the value of the overall portfolio.
A portfolio that offers the highest return for a given level of risk is said to be an optimal “efficient” portfolio. Any portfolio mix that plots below the efficient frontier is considered suboptimal because for the same level of risk there is another portfolio positioned higher on the frontier. Below is a list of the different asset classes we use to develop efficient portfolios for our clients.
Stocks are a main staple of any portfolio that hopes to appreciate in value over time. They are categorized by domicile and/or market capitalization — or market cap — which is the total value of the stock of a publicly traded company. It is equal to the current share price times the number of shares outstanding. Stocks come in a variety of sizes, and are typically clumped into the categories small, mid, and large cap. Breaking the different market caps out is important because they each have small, but meaningfully different risk/return profiles.
US Large Cap – These are publicly traded US stocks with market caps above $10 billion, and this segment makes up roughly 80% of the total value of the US stock market. Large cap stocks include many well-established household names like Apple, General Electric, Chevron, and Wells Fargo. They are a core holding that provides the portfolio with the potential for capital appreciation as well as an income stream in the form of dividends.
US Mid Cap – These are publicly traded US stocks with market caps typically between $2 and $10 billion. Mid cap stocks typically have a higher expected return than their larger cap brethren, but also tend to be slightly more volatile.
US Small Cap – These are publicly traded US stocks with market caps typically below $2 billion. Small cap stocks typically have a higher expected return than both large and mid cap stocks, but also tend to be more volatile than both. Smaller companies also tend to be more domestically focused than the multi-national companies in the larger market cap segments.
Foreign Developed – These are publicly traded companies domiciled in stable, developed countries such as Canada, the UK, Germany, Australia, and Japan. For the most part these are large cap stocks and include names like Nestle, Toyota, Samsung, and Diageo. They have a similar risk/reward profile and are strongly correlated to the movements of US large caps. Still, their differing currencies and geographic locations do provide some degree of diversification so they are included in portfolios.
Emerging Markets – These are publicly traded companies domiciled in developing countries such as China, South Africa, India, and Mexico. These are mostly large cap stocks and include names like China Mobile, Infosys, Embraer, and Lenovo. Investing in emerging markets carries additional risks such as political instability and currency risk, but the estimated return potential over the long-term is the highest among the equity asset classes listed here.
The traditional bond is typically debt issued by a corporation or government entity with a fixed coupon, otherwise known as an interest payment, made semi-annually. Traditional bonds are sought after for their price stability and predictable income streams and have long been the mainstay of conservative investment portfolios. Historically they have a very low correlation to stocks, making them great diversifiers. The bond world goes well beyond traditional core fixed income, though, as there are now a host of different sub-asset classes available to investors. Each of these offers a unique set of attributes that can be used to manage certain risks or increase expected returns in bond portfolios.
US Government Bonds – Treasury bonds with the backing of the full faith and credit of the United States Government. The yields will be lower on these bonds due to their low credit risk, but that’s the opportunity cost for safety. Treasuries are a great diversifier because they often have a slightly negative correlation to stocks, meaning they can often be up when the other is down and vice-versa.
Treasury Inflation Protected Securities – TIPS are a unique type of government bond first issued by the U.S. Treasury in 1997. They differ from standard Treasury bonds in that they provide protection against inflation. The principal of these bonds increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI). At maturity, investors are paid the adjusted principal or original principal, whichever is greater. The coupon rate is applied to the adjusted principal, therefore the interest on TIPS increases with inflation as well. The benefit of inflation protection comes at a cost, though, as TIPS have lower yields than traditional Treasury bonds with similar maturities. And just because an investment is safe does not mean it is stable. The price movements of these securities have historically been almost twice as volatile as that of the broader bond market (Barclays U.S. Aggregate Bond Index).
Agency bonds – these are bonds issued by government sponsored entities (GSE) such as Fannie Mae and Freddie Mac. They are not explicitly guaranteed by the government, but there is a sort of implied guarantee that if anything bad were to happen to them the government would likely step in. Because of this they tend to yield something in-between Treasury bonds and corporate bonds.
Municipal bonds – munis are issued by state, county, city, and other local governments and their agencies to fund construction projects. They are used to build schools, hospitals, and infrastructure such as bridges, roads, and sewage treatment facilities. They are also used for less noble projects, like building a stadium where people can go watch the Jacksonville Jaguars play. If they wanted to. Which they don’t. In most states munis are tax-exempt at the federal, state, and local levels, making them particularly attractive to investors in higher tax brackets.
Agency Mortgage Backed Securities – The Government National Mortgage Association, or Ginnie Mae (GNMA), is a government owned corporation that guarantees the principal and interest on certain mortgage backed securities. Because this guarantee is backed by the full faith and credit of the U.S. government, GNMA securities offer the same credit quality as US Treasuries. GNMA securitizes government-backed, single-family loans into “pools” of first-lien mortgages. Since these pools are subject to prepayment risk, the risk that a borrower pays off the mortgage early, GNMAs offer higher yields than comparable Treasuries despite having the same credit risk. Prepayments are highly correlated with falling interest rates which entice borrowers to refinance at a lower rate, as well as rising home prices which can spur more sales activity or tempt borrowers to cash-out their home equity. Prepayments normally force the bondholder to reinvest proceeds at a lower interest rate.
Non-Agency Mortgage Backed Securities – similar in structure to Ginnie Mae bonds, but without the credit-backing of the US Government. These are typically pools of non-conforming mortgages issued by bank and other lenders.
Investment-Grade Corporate Bonds – this is debt issued by a US company with a credit rating of BBB or higher, and is generally viewed as a relatively safe investment. The chances of an issuer of these bonds not being willing or able to pay back its obligations, known as default, are very low. The average annual default rate of a company with an investment-grade rating from S&P, for example, is only 0.10% (1981-2012). Corporate bonds almost always offer higher yields than US Treasury bonds.
High Yield Bonds – otherwise known as junk bonds, this is debt issued by companies with below investment-grade credit ratings (less than BBB). Investors demand higher yields to compensate them for increased credit risk. High yield bonds tend to be less sensitive to changes in interest rates relative to other bonds and more dependent on the strength of the balance sheets of the issuing companies. They have performed relatively well in rising rate environments because interest rates generally rise in stronger economic environments, and the risk of default tends to be lower when the economy is strong. The higher yields make these attractive investments and there is usually a small place for them in most portfolios. As one might expect, though, junk bonds have a higher default rate than investment-grade bonds — 4.22% from 1981-2012 according to S&P.
Floating Rate Notes – otherwise known as syndicated loans or senior bank loans, these are loans made by financial institutions to companies generally considered to have below-average credit quality. The loans are called “floating-rate” because the interest paid on the loans adjusts periodically based on changes in widely accepted reference rates, like LIBOR (London Interbank Offered Rate, in case it ever comes up in bar trivia), plus a predetermined credit spread over the reference rate. Floating-rate loans are classified as senior debt and are usually collateralized by specific assets, like the borrower’s inventory, receivables or property. Being first in line in the event of a credit default provides a degree of protection and higher recovery rates (around 70%) in the event of default than most other fixed income classes. This asset class is relatively less liquid but has historically demonstrated attractive returns with low interest-rate risk due to the floating-rate structure.
Preferred Securities – often called preferred stock, but just as Robert Duvall’s character in Days of Thunder astutely said, “there’s nothing stock about a stock car,” it’s a bit of misnomer for preferred stock as well. When we think of stock, we think of ownership and voting rights. But preferred securities are more like bonds. They have a face value (typically $25) and that’s what you get at maturity. So if the company’s common stock price goes up ten-fold it means nothing for the preferred stock shareholder. Maturities are often more than 30 years out, and in some cases they are issued in perpetuity. This means preferrerds often have very high durations and as such are highly sensitive to changes in interest rates. While they are still going to get paid before common shareholders in the event of bankruptcy, it usually isn’t much. According to a report from Moody’s, trust preferred securities had recovery rates of only 12.97% from 1982-2007 (on a value-weighted basis). The key attraction to preferreds is their higher yield and the tax treatment of that income. Much of the time the income is considered qualified dividend income, so it is taxed at a lower rate than interest income off a corporate bond. So if generating current income is a priority for you, there may be a place — albeit a small one — for preferred securities in your portfolio.
Foreign Bonds – these bonds are typically issued by sovereign nations in their local currency, often with higher yields than similar maturity U.S. Treasury bonds. For these reasons, they provide geographic and currency diversification and can be a good hedge against a falling U.S. Dollar. Conversely, the currency risk also means they would be negatively impacted by a relative rise in the value of the U.S. Dollar. Due to their global footprint, they may not be as heavily impacted by the changing interest rate environment in the U.S. These characteristics make foreign bonds a good portfolio diversifier. There are, of course, the political, social, and economic risks to be aware of.
We like to think of alternatives as assets that have a low correlation to stocks and bonds and offer a positive expected return. Including alternative investments in traditional portfolios of stocks and bonds shifts the opportunity set of risk/reward upward. They are not a miracle cure for downside risk, but they can reduce the overall volatility of a portfolio. Think of alternatives as the head gear you would wear in the boxing ring. They can help soften the blow, but that doesn’t mean you’re not going to get punched in the face every now and again.
Real Estate Investment Trusts (REITs) – an equity REIT is a company that invests directly in real estate and receives special tax treatment. To receive this special treatment, REITs are required to pay at least 90% of their net income to shareholders in the form of a dividend. There are a number of different REITs, and they invest in a variety of income producing properties including apartment buildings, storage facilities, hotels, health care facilities, shopping centers, office buildings, industrial facilities and timberland. REITs are a good hedge against inflation and help to diversify a portfolio’s income streams. They provide equity-like returns and bond-like income, but have low to moderate correlations with both asset classes and as such provide a diversification benefit to investment portfolios.
Commodities – Commodities are goods with little or no qualitative differential, meaning the market is indifferent as to who produces it. An ounce of gold is the same whether you buy it in London or Dubai. The fungible nature of these goods is the key to commodities markets. It allows a participant to trade large quantities at the same price knowing that every ton, bushel, or barrel bought meets the same criteria. There are many different kinds of commodities, but they typically fall into one of two general categories. Soft commodities, which are typically grown, include things like sugar, wheat, soybeans, live cattle, and lean hogs. Hard commodities are usually the kind that are mined, such as industrial and precious metals, or extracted, like crude oil. These commodities, unlike soft commodities, do not suffer from spoilage. The commodities space has been a difficult place to invest in over the past few years, but we like them not for their stand-alone merits but rather how they benefit the portfolio as a whole. Commodities have historically had very little correlation to equity and fixed income asset classes and, as such, provide diversification to an investment portfolio. They also provide a hedge against inflation and a decline in the value of the US Dollar.
Complementary Assets – this is anything else not listed above that can provide a positive expected return with little or no correlation to other asset classes. This can include a fund that bets against stocks (short selling), a manager who invests in options and other derivatives, or a fund that engages in arbitrage (the simultaneous purchase and sale of assets to benefit from a difference in price). These vehicles can be used to hedge specific risks or just to lower the overall volatility of the portfolio.