As investors, we frequently come across the term 'Asset classes'. What is an asset class and why do we need these?

Investopedia.com defines it as a specific category of assets or investments (stocks, bonds, cash, international securities, real estate).

Assets within the same class generally exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.

One way to 'diversify the portfolio' and 'spread risks' is by allocating the overall portfolio to different asset classes, bearing in mind the interaction between different asset classes. The goal is to create the most efficient mix of investments or asset classes with the potential to appreciate.

At the same time, this mix should also meet our risk and volatility tolerance, investment goals/ objectives, and our preferences for certain types of investments within these asset classes.

The selection of asset classes is a serious task, as the mix has an impact on the long-term risks and returns of the portfolio. Various asset classes have differing risk and return profiles.

In order to meet the requirements of portfolio diversification, categorised and classified information about the entire universe of available assets is a pre-requisite.

Diversification across asset classes helps reduce volatility, since investments across asset classes tend to perform differently under similar market conditions.

How? The downward movement of one asset class may be offset by the upward movement of another. However, inherent risks associated with investing in securities are not eliminated – diversification does not prevent losses.

Some key characteristics of asset classes can give us a basic idea to help with asset allocation:

• Assets within an asset class should have similar attributes. While equities are an asset class, a combination of real estate and equities is not.
• Asset classes should be mutually exclusive, and any overlapping will lead to confusion on the risk and return characteristics. Thus, if an investor's asset class is real estate (land or building), equities without real estate stocks would be more appropriate as another asset class.
• Asset classes should enable diversification. The returns of one asset class should not be correlated with the returns of other classes or a combination of other asset classes. If the return correlation is high, ie equities move up in tandem with real estate, then one would not get the benefit of diversification.
• The asset class should have the capacity to absorb a significant fraction of the investor's portfolio without seriously affecting the portfolio's liquidity. Any reallocation or rebalancing should not result in high transaction costs or cause significant price movements.

Before diversifying, investors should also consider the legal and regulatory framework in which they operate. There could be regulatory reasons limiting the choice of asset classes. For instance, banks and life insurance companies are frequently subject to regulatory restrictions limiting investment. 

Real estate laws vary from state to state and there are limitations on land transfers and usage. Tax implications should also be taken into account. A particular asset class may give high returns, but could also be subject to higher tax.

Traditional asset class divisions used by investors to diversify include:

• Domestic common equity
• Domestic fixed income: Investors may choose on the basis of the security (intermediate-term and long-term). Recently inflation protection has also been used to distinguish between nominal bonds and inflation-protected bonds.
• Non-domestic (international) common equity: Here, distinctions are made between developed market equity and emerging market equity.
• Non-domestic fixed income. 
• Cash and cash equivalents

Besides these, there are 'alternative assets', a term used to refer to all asset classes excluding the above. These include art, real estate, private equity, natural resources, commodities, currencies, derivatives and structured products.

Care should be taken that 'alternate assets' are further broken out as separate asset classes as they are far from being homogenous.

As India develops economically and people become more financially savvy, newer asset classes will be formed continuously to address the increasing need for diversification and portfolio allocation.

It is also important that the investor frequently evaluates his portfolio to find out whether the allocation strategy is still appropriate.

To sum up, a deeper understanding of the various asset classes and their interlinkages will help investors to comprehend the long-term implications of risk and return on the portfolio.

Author: IV Subramaniam, Director - Quantum AMC