Overview of Asset Classes

This valuation online course focuses on equity valuation. There are three broad asset classes – Equity, Fixed Income, and Alternatives. Cash is another example of an asset class, but here the focus is on  equity, fixed income and alternative asset class.  

Equity, Fixed Income and Cash are traditional investment and long only. Equities include listed equities that are traded over the stock exchange. Unlisted equities are part of the alternatives, not traded on stock exchanges, illiquid, have special taxation rules and carry more risk compared to listed equities. 

Fixed Income securities include sovereign bonds issued by the government, municipal, agency and corporate bonds and bonds issued by supranational agencies. Supranational Bonds issued for development purpose and formed by two or more central banks. Example, World Bank, Asian Development Bank. Agency sector issues securities for development purposes owned by central/federal government or Government Sponsored Enterprises. 

• Government backed Enterprises example Federal National
• Mortgage Association (Fannie Mae)
• Federal Home Loan Mortgage Corporation, or Freddie Mac
• Federal owned agency Ginnie Mae in the US*

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Corporate bonds known as the credit sector; corporate bonds are issued by corporations. They can be medium term notes, structured notes and commercial paper. Bonds categorized as investment grade and non-investment grade also known as speculative grade/High Yield bonds or junk bonds. Refer to the fixed income securities introduction for an in-depth coverage. In recent years another category, of bonds has emerged. Sustainable Development Bonds are special category bonds whose proceeds are used to target climate, social or governance driven or combination of these outcomes. Another category of sustainability-linked bonds focuses on key performance indicators for improving climate or social outcomes linked to their coupon payments rather than using proceeds of the bonds on the earlier mentioned themes. In sustainability-linked bonds coupon payments are linked to key sustainable development performance indicators. 

Shorting in a nutshell

Long on Procter & Gamble stock means you have purchased these stocks. On the other hand, shorting means borrowing securities to sell them to buy them at a lesser price. This type of style is an alternative strategy. Shorting is used when one has a bearish or negative view of a tradeable asset. For example, if a stock is trading at 300, you borrow the securities i.e. shares of a company from a broker/asset manager and sell the stock at 300. If the stock falls to 270, buy the stock at 270 and deliver them back to the broker/asset manager for a profit 30, keeping other factors constant example brokerage fees, etc. By buying securities at a lesser price, you return these securities to the broker or asset manager, making a profit through your trade. Further, the style includes leverage i.e. you can borrow much more than your capital invested. This topic has many more complexities like margin trading that will not be mentioned now. Traditional asset or style returns usually have a normal distribution, these asset classes are more liquid and carry lesser risk compared to alternative asset classes. Short selling mechanism is more complicated, this note is to familiarise with the concept. Short selling is not viewed favorably by everyone. One persuasive argument in favor of short selling is its leads to better price discovery. But this strategy could be used with leverage to cause havoc. George Soros shorted the pound to earn $1 billion of profit and this trade is covered in many publications and books. To know more about currencies and global macro, it’s important to know impossible trinity, an important concept in macroeconomics.

Understanding Alternative Investments – A look at Standard Normal 

Alternatives or alternative investments are the third categories of asset classes, these types of investments include hedge funds, private equity, or venture capital or include the use of leverage or derivatives as part of the investment style. Example long-short style of investing in equities used by hedge funds or derivatives. Historical returns are not good for analysing the future compared to traditional investments.

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For example in options pricing, implied volatility means what the market is implying the future volatility of a stock based on changes in options pricing. This example is enunciated to discern the difference between historical volatility and implied volatility. The return distribution of these assets don’t have a normal distribution, are less transparent, and have different measures to understand risk. These asset classes are good for diversifying risk from a portfolio as they are less correlated with traditional assets, but have shown a higher correlation with traditional assets during the financial crisis. Investments have concepts like hurdle rate, clawback, and waterfall structure that have to be looked at separately from that of traditional investments. Alternatives have a higher tail risk compared to traditional investments, many not linked to market prices. Some important differences between traditional and alternative investments are articulated here.  

Normal distribution follows a bell curve distribution, with skewness of zero, have symmetry about the mean, kurtosis of 3, and Mean= Median = Mode. The area of a normal distribution is always 1. Kurtosis measures the heaviness of tails or outliers. An excess of kurtosis i.e. if the measure is higher than 3 highlights a non-normal return with more data points away from the mean. Alternative investments have more observations or data points on either side of the mean. A better way to understand this concept is through a standard normal. Alternative investments have more observations or data points on abnormal distance on either side of the mean. A better way to understand this concept is through a standard normal. Usually observations above 3 standard deviation are outliers for normal distributions.

Above: Standard Normal | The middle Road 

Standard Normal has a mean of zero and a standard deviation of 1. This type of distribution standardizes variation of the observations from the mean through the 3-sigma rule – 68-95-99.7. 68 percent of the data points lie within 1 standard deviation of the mean, 95 percent within 2 standard deviations, and 99.7 percent within 3 standard deviations of the mean. Probabilities of expected returns falling within 1, 2, and 3 standard deviations (S.D) of the mean in a normal distribution.

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The Z-score of an observation is defined as the number of standard deviations it falls above or below the mean. Z-score for an observation X that has a distribution mean µ and standard deviation σ is below. Statistics online course will take a detailed look at standard normal. The Z-score of an observation is defined as the number of standard deviations it falls above or below the mean. Z-score for an observation X that has a distribution mean µ and standard deviation σ is on the left side. These concepts along with t distribution will be covered in the online course on Statistics.

Measures of risk adjusted return are Sharpe and Treynor Ratio. Sharpe ratio captures excess return over risk free security like T-bills in the US that have a zero-variance divided by standard deviation, Treynor divides excess return over risk free security by beta. These measures are good for asset returns that have normal distribution but not for nonnormal. Ratios like Sortino ratio, VaR (Value at Risk) and Expected Shortfall (ES) are used to understand downside risk.

VaR (Value at Risk) is the one of the most widely used statistical measure in financial risk management. It is a function of confidence interval expressed in percent and time measured in days. The confidence interval will be discussed in the statistical module going forward. Much of the content in the statistical online course is similar to that posted on the previous The middle Road site.  VaR statement gives a mathematical certainty in percent (confidence intervals in X%) that you are not going to lose more than a certain value of money over a specific time. 

N-day VaR = 1-day VaR * √N

Historic Returns of Various Asset Classes 

Below is a look at returns of various securities across asset classes. Reference data from Visual Capitalist. US large-cap stocks (ticker VFIAX) are an excellent barometer of the most liquid stocks in the US and for advanced countries. U.S. Small-Cap stocks will have more volatility than large-cap stocks, expected to outperform large caps. Being more volatile than large caps also implies that these stocks are expected to underperform large caps during financial distress. Small cap stocks should have a higher beta compared to large cap stocks. Beta is a measure of systematic risk, the undiversifiable risk of the portfolio. There are various ways in measuring beta, a more in-depth look during the discussion of capital asset pricing model using single factor model.

Data Source: Venture Capitalist | Calculation The middle Road | Refer to Venture Capitalist for tickers

The volatility data  is not available. Similarly, emerging market stocks are expected to give a higher return compared to stocks from advanced countries, and more volatile compared to stocks from advanced countries. International bonds are part of fixed income securities, REIT and Gold are alternative investments. REITS (Real Estate Income Trusts) are companies that own or finance income producing real estate, and are listed on various stock exchanges. They are very prominent in the US. Gold is a non income bearing precious metal, that is a safe haven instrument and a hedge against inflation. The importance of  alternatives is important for a better understanding of the Market Portfolio.

Efficient Portfolios 

Using Markowitz’s portfolio management theory, an efficient portfolio gives the best risk-adjusted return or the best return for the same unit of risk or portfolios that gives the highest expected return for any given measure of risk. Variance, i.e. the square of the standard deviation of the portfolio, measures the portfolio risk. Higher the risk of an asset, higher the expected return.

“Any asset or portfolio is efficient if it offers higher or expected returns for the same or lower risk or same or higher expected return for lower risk”

Securities across asset classes carry both systematic and unsystematic risk. Unsystematic risk is a diversifiable risk which means it can be eliminated by including more securities within the portfolio, unsystematic risk cannot be diversified away. Among efficient portfolios, the most superior portfolio is the market portfolio. The market portfolio consists of all tradeable risky assets. It’s easier to get equity and fixed income securities as many are listed on indexes and tradeable, but alternative investments example private equity, are not listed. However, REITS and Gold prices can be used as proxies for tracking alternative asset classes. Selected ETFs are alternatives, read more about ETF here. Due to a dearth of liquid alternative assets, S&P 500 is a proxy for market portfolio. The S&P 500 is regarded as a proxy for the U.S. equity market and as of 2018 was the the only stock market benchmark serving as an economic indicator in The Conference Board Leading Economic Index according to The Gauge of the Market Economy by S&P Dow Jones Indices. The middle Road refers to Investment Analysis & Portfolio Management by Reilly & Brown as one of the primary text book on the course on CAPM and Investment Analysis & Portfolio Management.

Below the selected assumptions for a market portfolio, an in-depth discussion will take during the capital asset pricing model.

Market Portfolio “Mother of all Portfolios” 

• Mean-Variance most efficient

• Portfolios include all tradeable risky assets within an economy

• A completely diversified portfolio and has no unsystematic or unique risk

• Includes only Systematic Risk or risk related to macro variables

• Beta is the covariance of an asset with the market portfolio

The risk section will discuss this aspect in detail. It’s imperative to understand how various asset classes behave before understanding equity valuation.