Asset Classes 101 – The Building Blocks of Your Portfolio

in Education-RSS, Personal Finance Essentials by

This is an overview of the asset classes for those who would like a better understanding of how they function. It is a very important thing to understand. While this may seem basic, unless you have a very strong financial background, there are likely to be important theoretical concepts worth reviewing.

There are nearly an infinite amount of investment choices available, but they conveniently fall into a rather short list of major asset classes. These are the ones you can choose from:

*Stocks (Publicly Traded Equities)
*Bonds
*Cash (And Cash Equivalents)
*Real Estate
*Commodities
* Private Equity
* Venture Capital
* Hedge Funds
* Collectibles
*Primary asset classes for most individual investors.

Stocks (Publicly Traded Equities)

What Are Stocks?

The ability to buy shares in publicly traded companies is one of the great things about global capitalism. The best part about owning stock in a company is that the company is legally obligated to work as hard as possible to increase share values. This means if you own Microsoft stock, about a hundred thousand people are waking up each day all around the world and spending their time working for you. That is very cool. It is also a main reason why owning stocks is one of the best ways to make money over time.

Simply, if you buy shares of a publicly traded company, you own a percentage of that company. As of this writing, Microsoft had about 8.7 billion shares outstanding. If you own 1,000 of them, this means you own about .00001% of the company. Usually, this means you control the same percentage of the voting rights in the company should any big issue arise, though often there are different classes of shares so you have will less voting rights. Most individual investors should not be overly concerned with voting rights.

Shares outstanding are not a fixed number. Companies have the right to issue new shares or buy back and “retire” existing shares. If a company issues new shares, either to raise money or to reward employees, your shares are diluted and you now own less of the company. In theory, you should not lose out in this scenario because management should only dilute your shares if it believes the long-term benefit to existing shares will be positive. In reality, you may or may not agree with management.

This brings us to an important point. Management is supposed to be focused on increasing shareholder value, but they often have conflicting interests, primarily getting rich. Especially if you are buying stock in company where management does not have a large equity stake, or in companies from Emerging Markets countries, you are likely to find shareholder value is not the number one priority.

Most publicly traded stocks are highly liquid and large volumes of shares are traded every day. For most investors, desired positions can easily be bought and sold immediately with very low transaction costs in all but the smallest companies. This is an important reason why stocks are such an important part of most people’s portfolios. Also, dividend payments and capital gains in stocks are taxed at reasonable rates.

Who Should Own Stocks?

Almost everyone. Despite high volatility, common stocks provide one of the best ways for most people to make sure their portfolio performs its task. The liquidity and relatively favorable tax treatment (currently) make owning stocks an obvious choice. The only question is how much and when.

How Does One Make or Lose Money with Stocks?

The beauty of equities is that they grow at a compounding rate. While a bond pays a set amount every year, the principal amount does not change. When the earnings of a company grows year over year, those gains compound, and so should your investment.

Stocks provide return potential in two ways, capital gains and dividends. In older times, companies used to pay out a higher percentage of profits as dividends. They pay less now because they figured out dividends are double taxed. They have to pay taxes on the corporate income and then you have to pay taxes on the dividends, so it is not a very efficient use of capital. Currently the dividend yield on the S&P 500 is just over 2%. This means for every $100 you own, you would get about $2 a year in dividends. Historically, about 30% of investor returns come from dividends. The rest is from capital gains which are achieved when you sell a stock for more than you bought it for. In taxable accounts, capital gains are currently taxed at 15% if they are held for over a year and as ordinary income if held for less than a year. Most stocks pay qualified dividends which are currently taxed at 15%. These tax rates are scheduled to expire at the end of 2010 and will likely increase.

Over time, stocks tend to gain in value because the people employed by the companies are hard at work innovating and finding ways to increase future earnings. But if the market is efficient, shouldn’t the price reflect those efforts already? Maybe, but it usually does not because regardless of the long-term profitability of the corporate world, stocks are still subject to wild price swings for other reasons. Most people are intimidated by this volatility and so the market price is usually below the expected value.

This is the basic risk and reward tradeoff.

According to data compiled by Bloomberg and Standard & Poor’s, corporate earnings for the S&P 500 increased just less than 6% per year from 1960 through 2009. Based on Robert Shiller’s calculations, the longer term growth rate is closer to 4%.

So, how can equity returns exceed the growth rate? There are three ways.

First, theoretically, if a company can pay out some of its earnings in dividends, but still maintain the same earnings growth rate, shareholder returns will exceed the earnings growth rate by the amount of the dividend.

Second, even if a company’s earnings are not increasing, its value can increase if it is investing in assets that maintain or increase in value. For example, much of the value of some retail companies is in the land they own. If a restaurant chain that buys its locations grows its earnings by 3% per year, but it also grows the number of restaurants by 5%, theoretically, the company should gain in value by more than 3% because the shareholders now also own more valuable real estate. This gets a bit confusing because basically the value of stocks is based on future earnings potential, but book value is also important because theoretically it could be turned into earnings if the company chose to start liquidating.

Third, the multiples people are willing to pay for earnings can increase. This explains a meaningful part of the gains of the last 50 years. Of course, this part can go the other way also.

Shouldn’t all this be priced into the current value? Yes, but…

Stocks provide high returns because they are risky to own.

Over long periods of time the total return should roughly = the dividend yield + earnings growth.

If the economy continues to function and grow, holders of stocks should be rewarded as risk passes with time. The better the outlook for future earnings, the greater the reward will be.

The short term results of owning an individual stock is primarily dependent on the outlook for the future profitability of the specific company. The long term results should roughly equal the dividend yield plus the earnings growth. Remember, though, if an individual stock starts with an extremely high or low valuation, this will lower or increase returns, respectively. For this section, we assume you will own a diversified stock portfolio and are more concerned with what makes the equity market as a whole move.

Short and intermediate term price movements of stocks are determined solely by supply and demand.

There are an endless number of reasons why supply and demand change, including availability of capital, valuations, earnings estimates, interest rates, taxes, political changes, and on and on. Our purpose here is to understand the basic behavior of the asset class, not to try to time its movements, so we will stick to a high level overview.

Supply of equities is relatively fixed in the short term, but can change considerably over a period as small as even a few years. When it is easy for companies to raise capital by selling shares, either in an initial public offering (IPO) or a secondary offering, friendly investment bankers rush to help them do so and supply goes up. When shares appear undervalued, companies may buy back and retire their own shares or private equity investors may buy public companies and remove them from the market. Supply goes down. Supply changes can be an important indicator of future market returns.

Demand changes quickly, even in the short term, and is responsible for daily market fluctuations. The most important drivers of demand are availability of capital and risk appetite, not economic cycles. Market cycles do tend to closely resemble economic cycles, but not for the reasons most people think. The common belief is that in a recession people expect the future earnings of a company will be lower. Therefore the stock should be worth less. This may be true, but the value of a stock is based on all future earnings, not just the next few quarters, so a dip due to a recession should not affect the long term value that much. However, in a recession and in the period just before one, companies and individuals find they need to hoard capital until they know the severity of the downturn ahead. Buying slows. People who have leveraged themselves may need to raise capital to meet obligations. In recessions, banks often restrict lending, but equities remain liquid. Selling increases.

Once this initial cause of price declines gains momentum, some people who don’t need to sell get scared and their appetite for risk declines. They sell stocks and buy something perceived as safer. This probably explains why most of the declines in a bear market usually come in a relatively short time period at the end of the bear market. Bull markets tend to climb slowly as credit expands. Almost every bubble in history was the result of a new way to expand credit. In the most recent example, the creation of “low-risk” securitized mortgages allowed banks to believe they could lend money to people who probably were not good candidates. Once these lenders spread the money around, some of it went into the stock market. When credit dried up, people needed to sell stocks to ensure they could meet obligations.

Historical Experience and What to Expect:

History and theory are the only tools we have to guess what future equity returns will be. They are far from complete, but they are our best guide. History suggests owning stocks is a lucrative endeavor. The average annualized total return of the S&P 500 since 1926 is about 10%. Almost everything you see in the investment world is focused on what the markets will do in the next 6-18 months. This is important, but you should be more concerned about what equities will do in the next 30 years, or whatever your time horizon is.

Unfortunately, using very long periods of time as a guide creates conflicts. On one hand, the conventional wisdom says longer periods of time ensure you will recover from bear markets, even severe ones. At least in the United States, this has always been the case, and it favors very high equity allocations.

The other argument would be that the longer the time horizon, the greater the chance of historical patterns breaking down with a prolonged period where equities meaningfully decline or lag inflation. In my opinion, it is not worth worrying about the case that equities become totally worthless. While possible, this implies that the whole economic system has collapsed and cash and other asset classes would probably also be worthless. Historically in the world, this happens more than people (especially Americans) tend to acknowledge, but it is still not a good reason not to have a large allocation to equities.

But stocks are volatile. This is true more than most people appreciate. Since 1926, the S&P 500 rose or fell more than 10% in 70% of the years and rose or fell by more than 20% in 45% of the years.

Average should not be considered normal.

This period includes the Great Depression. Many people exclude this period from analysis, but I believe this is a mistake. Depressions close to its magnitude were fairly common in history before the 1920’s and have happened in numerous places around the world since. Hopefully Americans have developed the tools to avoid another such situation, but I think it is foolish to assume that is necessarily the case. The fact is we came disturbingly close to a financial breakdown in 2008.

Another important takeaway is that during this period, every bear market recovered fairly quickly. The longest recovery using calendar years took just 5 years to get back to breakeven (after the 1930 peak). The average bear market recovers in about 2 to 3 years. This argues for owning a high allocation to equities. But let’s hold on a minute and think about that.

The first point is that these are nominal returns. If you adjust the numbers for inflation, stocks have posted negative returns for over a decade on a few occasions, including the 00’s. Actually, due to the close proximity of two major bear markets, even the nominal return for the decade ended in 2009 was negative. Still, if you never take distributions from an amount allocated to equities, historically you would always have recovered. But let’s say you have a million dollars and want to spend 5% of the original starting value each year, just $50,000. In the Great Depression, if you were unlucky enough to have started at the peak, you would have run your account to zero and been left in the bread line. If you started this scenario in at the end of 1999, you would be starting 2010 with $380,000, not even adjusting for inflation. This is an unenviable scenario in which you would be forced to reduce or eliminate your distributions unless you were nearing the end of your time horizon.

The Japanese Nikkei Index ended 2010 down over 50% from its peak in 1990. Our hypothetical Japanese investor with $1,000,000 and taking out $50,000 a year would have been completely wiped out in 2002. No matter how strong the recovery is, you can’t recover if you have already lost everything. Could such a thing happen here? Of course. It is unlikely, but highly possible. Luckily, these days it is easier and easier to build a global portfolio which reduces country specific risk, but this only helps so much, especially because correlations between returns in different countries have been steadily increasing.

The bottom line is equities have usually offered good returns and should continue to do so. They are an important part of any well built portfolio, but they are volatile and must be treated with healthy respect.

Benefits:
High expected returns
Extremely liquid
Reasonable tax treatment
Low transaction and carrying costs
Low maintenance

Cons:
Volatile

Bonds (Fixed Income)

What are Bonds?

Bonds are debt. Basically if you buy a bond, you are lending someone money in exchange for an interest payment. It’s that simple. Most bonds have a principal amount, a set periodic interest rate, and a set maturity when the principal is due to be paid back. Some bonds have more complicated arrangements.

The debt market is vastly bigger than the equity market.

For a good general overview about the very basics of bonds, check out InvestingInBonds.com and/or Pimco.com

The price of a bond and its yield move in opposite directions. If I owe Bob $1,000 and the price of that debt is $900, the debt has a yield of 11.1% (($1,000/$900)-1). The math gets more complicated if you factor in periodic payments, but this is sufficient to make the point. If you buy my debt from Bob for $950, the price goes up $50, but the yield drops to 5.3% (($1,000/$950)-1). Note that I don’t care what the price is because either way I still owe $1,000, although if the price drops low enough I may buy back my own debt (perhaps by creating a new debt with someone else at a lower yield).

The most common bonds fall into one of these categories:

US Government Bonds – Backed by the US Government, these are considered very low risk but pay relatively low interest rates. Loans issued by the government to be paid back within one year are usually called Bills, to be paid back between 2 and 10 years are called Notes and those with maturities longer than 10 years are called Bonds.

US Municipal Bonds – Backed by various US states or municipalities. These bonds are relatively low risk, though there is some precedent for default. Many of these bonds are treated as tax-exempt meaning they could offer attractive yields to investors in a high tax bracket and need to be avoided in tax-exempt accounts.

Foreign Government Bonds – Loans backed by foreign governments. These are usually considered low risk but are subject to currency risk.

Corporate Bonds – Loans to companies. These are broadly classified as investment grade and non-investment grade (or junk) bonds. The higher the perceived risk of default, the higher the return is if the debt is fully paid. For US investors, it is usually difficult to get access to foreign company corporate debt.

TIPS – US Government debt that is indexed to inflation. It is important to understand that the price of these bonds moves based on changes in the expected inflation rate, not the actual rate of inflation. Still, they can be a good investment in times of rising inflation.

Mortgage Backed Securities – A mortgage-backed security (MBS) is an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans, most commonly on residential property.

First, mortgage loans are purchased from banks, mortgage companies, and other originators. Then, these loans are assembled into pools. This is done by government agencies, government-sponsored enterprises, and private entities, which may guarantee (securitize) them against risk of default associated with these mortgages. Mortgage-backed securities represent claims on the principal and payments on the loans in the pool, through a process known as Securitization. These securities are usually sold as bonds, but financial innovation has created a variety of securities that derive their ultimate value from mortgage pools.

Most MBS’s are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as “private-label” mortgage securities.

Callable Bonds –This is any type of bond where the borrower has the right to repay you at a certain price and a certain time. These bonds should be cheaper to buy, but if interest rates go down, you are likely to have your bond called away from you and have trouble reinvesting at the same interest rate the bond was paying.

Convertible Bond – This is a bond that provides the option of trading it in for a certain amount of common stock of a company in exchange for a lower interest rate. These bonds can be very profitable if they stock rises significantly. Occasionally, price inefficiencies make these bonds appealing, but they require more analysis than regular bonds.

Who Should Own Bonds?

Most financial advisors suggest at least some allocation to bonds. Traditional wisdom says that the older a person is (or the shorter their time horizon), the more bonds they should own. This is because bonds are considered to be a relatively stable source of returns compared to other asset classes.

Bonds are a useful part of most portfolios. They can provide a stabilizing element with decent returns, but many people own more bonds than they probably should because they are overly cautious or do not understand the risks of bonds.

Depending on how you look at it, bonds are not safe investments, especially for those who require high returns. If inflation rises significantly, owners of bonds can be hurt very badly. For investors who are trying to be conservative and simply keep up with inflation, this can be devastating.

On the opposite side of the coin, some bonds can be a fantastic part of a more aggressive portfolio, but are often ignored. Coming off the bottom of the bear market in spring of 2009, a popular US High Yield Corporate ETF, symbol HYG, was yielding about 15%. As it became clear that the world was not ending, this ETF provided a total return of about 50% through the end of the year. Yes, this slightly lagged the S&P 500 return for the same period, but it was still pretty good and was probably a lot less risky than owning stocks.

A problem with bonds is they are less liquid than stocks. Most bonds can be sold by any major broker, but the volume in each bond is usually very small. This means there is a considerable “bid-ask spread” on most bonds, especially if you are dealing in lots under $100,000. Spreads of 5% are very common. This is not usually an issue with Treasuries. For this reason, bonds are usually bought to be “held to maturity” and are not good instruments to trade frequently. Even when held to maturity, transaction costs can eat into already low returns, especially if one builds out a meaningfully diversified portfolio. This can be avoided by buying bond funds. In recent years, a number of attractive diversified bond ETFs have also been established and can be a good way to obtain exposure to the asset class. It is important to be wary of management fees with bond funds and bond ETFs.

How Does One Make or Lose Money with Bonds?

Returns from bonds come from either interest payments or capital gains. Interest payments usually come in semi-annual payments of a set amount. Some bonds are “zero-coupon”, meaning they do not make interest payments. To attract investors, they are sold below par. For example, a bond paying $1,000 at maturity may be sold for $900. Interest payments are usually taxed as ordinary income, with the big exception of municipal bonds which are usually tax free.

Capital gains (or losses) are realized when a bond is sold for more (or less) than it is purchased for. If the position was held under a year, gains are taxed as ordinary income while positions held for over a year are considered long term capital gains – currently taxed at 15%, but likely to rise to at least 20% after 2010.

Price movements in bonds are caused by changes in the reality or perception of one or more “risks”. The most important are listed below. In the industry, they are called risks, but please note that depending on when you buy a bond, they can just as easily move in your favor and cause the price of your bond to go up.

Interest Rate Risk – If prevailing interest rates go up, the coupon being paid on existing bonds is less attractive, so the price people will pay for them goes down.

Default Risk – If it looks more likely that the issuer of the bond will be unable to pay its coupons or its maturity price, the price of the bond will drop. Even if a company goes bankrupt, bond holders are usually able to recover a fraction of their original loan. US Government debt is considered to have very little default risk because they can print more money if needed to meet obligations, although lately there is increased concern that the government credit ratings will be reduced meaning new debt will cost more and old debt will be worth less.

Inflation Risk – Bond coupon (interest) payments are generally fixed amounts. When the rate of inflation rises, bond prices tend to fall because the purchasing power of the fixed coupon payments is reduced.

Currency Risk – Bonds that pay interest in a foreign currency are subject to losses in dollar terms if that currency declines against the dollar.

Two key concepts of bond investing are maturity and duration. The maturity is the length of time until the principal of the bond is to be repaid. In very simple terms, the duration of a bond is a measure of its price sensitivity to interest rates. The price of a bond with a duration of 5 would move about 5% for every 1% change in annual interest rates. Generally speaking, the longer the maturity, the higher the duration. It is not as bad to be stuck in a low interest rate bond for one year as it is to be stuck in it for ten years. On the other hand, it is better to be the owner of a high interest rate bond for ten years than for one. It is because of this increased risk that longer maturity bonds usually pay higher interest rates, though this is not always the case.

Historical Experience and What to Expect:

This section is challenging to write concisely because there are many different types of bonds with different histories.

US Government bonds have never defaulted. Despite increasing talk about lowering the debt rating of the US, it is very hard to imagine the federal government defaulting because they can always print more money. You may lag inflation by owning US government bonds, but you will probably not lose your principle.

With an individual corporate bond, there is a reasonable chance of default. You can usually assess the risk level by checking the credit rating of the company, though if the last few years have taught us anything, it is that the rating agencies are a total disaster and are largely inept. Owning a diversified corporate bond portfolio can provide decent returns with little chance of massive losses. The problem is that corporate bonds are highly correlated with stocks, limiting their overall appeal in a balanced portfolio that contains equities.

As previously stated, in periods of time when interest rates are increasing, bond holders do very poorly. In periods of time when interest rates are declining, bond holders do well. For this reason, bonds were a terrible investment in the 1970’s and have been pretty good ever since. Because interest rates are pretty low right now, one could argue that there is more downside risk than upside potential in bonds at the moment.

While less risky than stocks, bonds tend to be more volatile than most people fully appreciate.

Benefits:
Provides a relatively predictable income stream
Relatively highly liquid – though transaction costs can be meaningful
Occasionally provides opportunity for high returns

Cons:
Returns over time tend to be lower than equities
Highly subject to inflation risk
Corporate bonds are highly correlated with equities
Tax structure is unfavorable (except Municipal bonds)

Cash (and Money Markets)

What is Cash?

Cash can be held in the form of currency, bank checking or savings accounts, money market funds, bank CDs or very short term US Government debt. Cash is considered the least risky asset class as it is not supposed to ever lose its base value. Therefore, returns are very low. The main risk is inflation risk.

Currency – most people hold very little actual currency. This is smart because it generates no return and is possible to lose to theft or fire. Still, it is a good idea to keep at least a small amount handy at all times in case of emergency.

Bank Accounts – If you are going to hold a significant amount of cash in a bank account (which you probably should not), find one that is FDIC Protected and pays a high interest rate. Up to $250,000 per depositor per bank can be FDIC Insured. You probably should not keep more than this in bank accounts to begin with, but if you do, consider opening multiple accounts at different banks to take advantage of the free insurance against the bank going under with your assets. Once again, this is pretty unlikely, but if it happens, you will be glad you thought about it. The FDIC website proudly states that “In the FDIC’s 75 year history, no customer has ever lost a single penny of insured deposits.” This is reason enough to be wary, but still, you should be safe with these accounts.

Money Market Funds – A money market fund is an open ended mutual fund that invests in short term debt obligations, frequently treasury bills. They are usually pegged to $1 per share but make interest payments. They are not FDIC insured, but are considered safe. There have been a few instances of money market funds “breaking the buck” (losing value) but they are very rare and if the parent company is financially sound it will usually cover the loss to save reputation (as happened in 2008). Even if a money market fund does break the buck, it may only go down a few pennies per share. Find one that pays a high rate, but not too high of a rate. If a money market is way off the bell curve compared to its peers, it is probably investing in something risky. It is usually very easy to switch money markets and it is worth your time to do it to get the extra yield if you are not already in a high paying one. If you are going to leave a meaningful amount of money in cash for a long time, you will usually be better buying actual short term treasuries instead. That is what your financial provider is doing, and then they charge you a management fee for the convenience of having a money market fund. You may be amazed at the difference in interest rates even among funds at the same custodians. If you don’t ask, they will not move money to the higher yielding ones. Even if you maintain a small cash allocation, it is worth the effort to get an extra 1% or so every year. For example, as of this writing, all the Schwab Money Markets effectively pay zero interest. However, if you open a free investor checking account, you will get 0.75%. This type of scenario is common at all major custodians. Don’t ignore the tax-free options if you live in a high tax state.

CDs – A CD is sort of like a bond issued by the bank, and it is FDIC insured (again for up to $250,000 per person per bank). It provides a higher yield than a checking or savings account, but you commit to keeping the money locked up for longer and usually pay a fee for taking it out early. Once again, look for high rates, but be wary of CDs that pay way more than competing banks. This usually means the bank in question is desperate for funds. Even if it is federally insured, it is not a fun situation to deal with if your bank goes under. Note that CD interest earned is taxable at both federal and state levels. Interest earned on Treasury bonds is exempt from state income tax. Otherwise, go for the highest yield as long as you are sure you won’t need the money if it is locked into a CD.

Who Should Hold Cash?

Large allocations to cash are usually not part of a successful investment strategy. Occasionally, when other asset classes are unappealing, a larger weight may be considered. Most people don’t put much thought into how they manage their cash, but it is worth some effort to get it right.

Not considering any “safety fund”, your allocation to cash should usually be below 5% of your long term investment portfolio, unless you have known expenses.

Required distributions should sometimes be kept in cash or short term government debt unless you wish to leverage the portfolio related to the value after the distribution.

Sometimes, the outlook for other asset classes such as equities and bonds is particularly unattractive. If this is the case, you may want to hold a higher allocation, maybe even 100% of your assets, in cash temporarily. As a general rule, never do this for more than six to twelve months unless you need the money for something. Cash is an awful long term strategy and your timing on predicting a bear market will not be perfect.

Historical Experience and What to Expect:

Cash in the US has acted as a store of value, though there have been times of high inflation in which low yielding cash equivalents can lose a meaningful amount of their purchasing power. It is extremely rare for cash investments to meaningfully outpace inflation.

Benefits:
Almost no risk
Immediate liquidity (except CDs)

Cons:
Low returns – usually will not keep up with inflation

Real Estate

What is Real Estate?

Individuals can invest in real estate in a number of ways. Most people already have a fairly major investment in their primary residence. This should be considered in your overall allocation because it is a major asset. You may not want to sell your house, but you could. A key aspect of primary residences is whether it is owned outright or leveraged through a mortgage. Home equity mortgages, due largely to tax incentives created by the government, often allow one to leverage returns efficiently. If you have a mortgage, you should consider the amount as a negative value in your bond allocation (debt) and the full value of your home as allocated to real estate.

Other ways to invest in real estate are buying investment properties, investment in private real estate funds or partnerships, or buying publicly traded REITs. REITs are pooled investment trusts that do not have to pay corporate income tax but are required to pass along at least 90% of taxable income to shareholders. For this reason, currently REIT dividends are not considered “qualified” and are taxed as ordinary income. REITs are usually specialized in one area such as residential homes, hotels, industrial properties, etc. REITs behave somewhat differently from other stocks, but tend to be highly correlated to the overall market.

Who Should Invest in Real Estate?

Most people with meaningful assets already own their primary residence. Generally, this is a good idea, though not for everyone.

Other than that, most people should skip real estate as an asset class almost entirely. You should only consider directly investing in properties if you have expertise in it or are willing to spend a lot of time managing this investment. Remember that properties are illiquid and can take a long time to sell in a weak market, perhaps years.

REITs are traded on the standard stock exchanges and are a much easier to own than actual property. Because they have become so highly correlated to the overall stock market in the last decade and are driven by many of the same demand factors as other stocks, I believe they should be considered part of an investor’s equity allocation. Here, they belong in most equity portfolios. If you are actively managing your account, you can try to time when to overweight or underweight REITs. Otherwise, maintain a market weight, about 3-5%. Even allocations up to 10% can be appropriate. This is most effectively done by owning a REIT ETF, preferably Vanguard’s offering, VNQ.

If you buy individual REITs or a REIT specific ETF, try to own them in a tax-deferred account due to the high dividend yields and unfavorable tax treatment of them.

Private real estate funds and partnerships vary widely. They are difficult to access for most people and are only recommended if you have a personal relationship with a major partner of the project who you trust implicitly. Only invest in these if you expect a large return if things go well and you can afford to lose the whole investment if it doesn’t. Plan on the later.

How Does One Make or Lose Money with Real Estate?

Before getting too excited about Real Estate, please remember that the value of any building depreciates over time. Usually, the land will increase in value. There is no fundamental reason why real estate should increase faster than inflation unless the population is growing faster than supply can be added.

In fact, overall, real estate prices historically have appreciated at about the rate of inflation, though of course there are large fluctuations year by year. For your primary residence, your gains come from appreciation plus the cost you are saving on rent (many people view owning a home as a right, but it is undeniably a form of consumer consumption) minus the taxes and maintenance costs on your home. If you have a mortgage, the gains or losses will be leveraged, but you need to also subtract out mortgage payments and add back in tax savings from deductions on interest payments.

Gains in investment properties are achieved from appreciation in the property and rental yields. Rental yields are a function of supply and demand in the rental market. When the economy of a certain area is rapidly growing, people and businesses will want to rent space and yields will go up. For this reason, the yield function of real estate returns is very sensitive to economic cycles.

Real estate prices, like everything else, are a function of supply and demand. Most properties are bought with the assistance of some type of loan, so availability of credit is one of the most important drivers of demand. Also because of this, higher interest rates reduce demand and lower interest rates spur demand.

Another key factor in demand is population growth and demographics. As I suspect the developers in Dubai will painfully continue to discover, and China soon, if you have a lot more properties available than you have people with the money to buy them, prices must fall. One reason property values have increased fairly consistently in the US is that the population has grown fairly steadily. In Japan, real estate has fallen fairly steadily for the last twenty years. There are many reasons for this, but a lack of population growth one big one.

Supply is increased when developers believe they can profitably sell new houses or commercial buildings after all the costs that go into construction. You will know when we get to the next real estate bubble when you start to read stories about how difficult it is for builders to hire construction teams. Supply is rarely decreased except for the occasional building that is demolished.

Benefits:
You get to live in and enjoy your primary residence
Meaningful diversification from other asset classes
Favorable tax treatment on gains
Relatively low volatility

Cons:
Illiquid
High transaction costs
Time consuming
Low historical returns

Commodities

What are Commodities?

Commodity investing is betting on the price movement of a certain amount of a physical commodity. There are a very large number of commodities you can speculate on. Some of the major ones are oil, natural gas, gold, silver, copper, coffee, corn, pork bellies, cocoa, wheat, etc. You can get exposure primarily in the following ways:

Buy the physical commodity

Buy stocks or ETFs representing stocks sensitive to commodity prices

Buy ETFs representing the actual commodity price movements

Trade futures based on the commodity price movements

Unless you own a grain silo or really like pigs, you will not be buying physical commodities. The exception could be gold or silver. I personally have never felt the need to own physical gold, but some people feel more comfortable with it and that is fine. ETFs representing stocks of commodity based companies can be a decent way to play a belief in a direction of a certain commodity, but they remain subject to many of the forces of the overall stock market. Here, we will consider these investments as part of your equity allocation and not direct commodity investment.

ETFs representing commodity price movements are a valid way to speculate on commodity moves. Unfortunately, the universe is somewhat limited. GLD is highly liquid and seems to be a decent way to get gold exposure, though it does have a cost. Other ETFs have inherent problems in that they are forced to constantly buy and roll futures, which can be expensive and create losses. Be careful buying commodity based ETFs, especially ETNs where you also have exposure to the health of the issuing company. Resist the temptation to buy leveraged commodity ETFs unless you insist on gambling over holding periods of less than a week. And don’t do that more than a few times a year.

Most serious commodity trading is done with futures. A future is an agreement to buy or sell a certain quantity of something at a future date. Some people use commodity futures to reduce risk in their business. For example, airlines can lock in the right to buy fuel at a certain price, thereby stabilizing the cash flows of their business and allowing them to keep ticket pricing more stable. Southwest’s superior fuel hedging program was what helped them dominate the domestic air market for a good chunk of the last decade. Futures can also be used to speculate. You often hear stories about large sums of money being made and lost very quickly in futures. This is often the case because it is possible to trade a large amount of a commodity with a fairly low amount of margin (collateral). Therefore, many trades are highly leveraged. It is not difficult to set up a futures account if you have a decent net worth and tell the brokerage firm that you know what you are doing, but unless both of these are actually true, there is no need to have a futures account. If you are not already a futures expert, you are not missing out on anything you need.

Who Should Invest in Commodities?

You may have noticed words like bet, speculate and gamble more in the commodities section than elsewhere. Commodity prices generally increase with inflation, but otherwise they are zero-sum. When people trade commodities, somebody wins and somebody loses. Therefore, most people with long-term goals do not need direct exposure to commodities.

In actively managed portfolios, I do think a small allocation to gold (meaning 1-5%) is occasionally appropriate as a diversification tool or to attempt to boost returns on your cash allocation. Gold is often cited as a great inflation hedge or protection against a falling dollar. In rough terms, it is both of these things, but it is an inefficient way to play these themes.

Whatever the guys on TV in the middle of the night are telling you, you don’t need much gold. Long-term it is not a good investment.

How Does One Make or Lose Money with Commodities?

You make or lose money on commodities if you bet on the right side of their price movements. Commodities are just things. They don’t pay you dividends or interest. Commodities futures have unique tax treatment. Gains are taxed 60% as long term capital gains and 40% as short term capital gains. Unrealized gains at the end of the year are marked to market and you must pay taxes on them.

Benefits:
Provide diversification from other asset classes
Liquid, low transaction costs
Tend to act as an inflation hedge

Cons:
Low historical returns (though some people make or lose a lot trading)
Unfavorable tax treatment for long-term investors
High volatility

Private Equity

What is Private Equity?

Private equity is ownership in companies that are not publicly traded on an exchange. If you own your own company, you own private equity. Private equity funds buy parts or whole companies with the goal of selling them later for more money, either to another private investor or into the public markets. The kind of private equity funds that get the most media attention are the ones that acquire whole companies, often public ones listed on the stock market. Once they gain control of the company, they tend to issue a lot of debt in the name of the company to pay for much of their purchase. This is known as a leveraged buyout (LBO). The effect is that they end up with a highly leveraged company. If they can improve results and sell the company back to the public or to another company for more money, the gains can be very large. This causes controversy sometimes because they put otherwise healthy companies in more perilous financial condition and risk driving them to bankruptcy. This is very bad for existing bond holders in the company and may be bad for the employees of the company. Note that it is good for the old stock holders of the company, usually including management who may also get a stake in the gains of the newly restructured company. This is not the place for an analysis of the social benefits or costs of private equity funds, but to be fair I should note that they also provide a stabilizing feature to the stock market because if a company’s shares become too low people may start to buy them in anticipation of a private equity company making a bid. They also play a role in extricating bad management teams or poor operating methods from otherwise high potential companies.

An important aspect of private equity is that there is no ready market to sell to. The only way to create liquidity is to find another private buyer or initiate an IPO (Initial Public Offering), which is expensive and may not fetch a good price depending on current market conditions. Private equity returns have tended to be high because of the extra risk involved in leveraging the companies and the lack of liquidity.

Capital for private equity is raised primarily from institutional investors. For the typical investor, other than starting a business or investing in a private company of someone you know, the only way to invest in private equity is through private equity funds. These funds often require substantial initial investments and charge very high fees.

Who Should Own Private Equity?

Currently, most private equity investment is done by institutional investors. In my opinion, there is not an attractive way for the average investor with less than ten million or so in liquid assets to own private equity.

How Does One Make or Lose Money with Private Equity?

Investors in private equity make money in one of three ways.

  1. Because the company is private, the owners are free to keep as much of the cash flow generated by the company as they wish. Of course to maximize the long term value, much of the cash flows will be needed to reinvest in the company.
  2. Selling the company for a higher price due to improved operations or increased cash flows.
  3. Selling the company for a higher price due to multiple expansion.

Losses accumulate when the purchased companies can’t be sold for higher prices and do not generate excess cash flows. If the company can’t meet its debt obligations, the company must file for bankruptcy and equity holders are likely to lose some or all of their stake.

Historical Experience and What to Expect:

Private companies and private equity funds are under no obligation to report their results, so it is impossible to know what historical returns have been. In theory, and though circumstantial evidence, private equity returns are high. This compensates for the high risk, lack of liquidity and significant expertise needed to invest in them. Private equity is subject to booms and busts largely tied to the public markets which set the tone for the valuations private equities can be sold for. Expectations for high returns led to increased investment in private equity from institutional investors in the last decade. This increase in supply has probably made it harder for private equity managers to find good investments and should lower returns looking ahead. Indeed, as credit dried up and stock values fell in 2008, many private equity investors suffered large losses.

High fees for private equity managers make return assumptions less attractive for investors.

Benefits:
Potential for high returns

Cons:
Illiquid
High fees
High correlation to public equities
Lack of transparency

Venture Capital

What is it?

Venture capital investing is similar to private equity, but it is focused on new, start-up companies with high growth potential. Also, venture capital investments usually only acquire a part of the company, not the whole thing. Cash investments are usually made in exchange for shares in a new company. Venture capital plays a vital role in fostering innovation and helping new companies raise capital to develop their products and services. Venture capitalists often also provide expertise and advice to the companies they invest in.

Who Should Invest in Venture Capital?

Currently, most venture capital investment is done by very wealthy individuals or by institutional investors. Some venture funds will accept investments from smaller individual investors, but in my opinion, there is not an attractive way for the average investor to access venture capital in a properly diversified manner.

How Does One Make or Lose Money with Venture Capital?

The primary objective with venture capital investments is to sell the stake in the company for more money, either to another company or through an IPO. Venture capitalists tend to accept that most investments will be losers but hope to compensate with one or more huge gains.

Historical Experience and What to Expect:

Once again, there is no official way to track the historical results of venture capital investments. Undoubtedly, there have been some huge successes. Theoretically, returns should be high because of the high risk, low liquidity and substantial expertise required. Returns vary significantly by fund and also by the timing of investments.

Benefits:
Potential for high returns

Cons:
Illiquid
High fees
High correlation to public equities
Lack of transparency

Hedge Funds

Hedge funds like to shroud themselves in mystery, probably because it is easier to justify their outrageous fees if people don’t really understand what they are doing. Basically, a hedge fund is simply a pooled investment fund that has a wider range of investment choices than a typical long-only equity fund. The name implies that the fund is using at least one instrument to offset the risk of others, and many times they do. But a hedge fund can just as easily be long only or leveraged totally in one direction. Another misperception is that hedge funds all strive for very large returns. Some of them do, but many of the biggest ones are content to try and earn a few percentage points above inflation. It is really not possible to describe hedge funds in one manner because they are very different from each other.

Some of the most common types of hedge funds are these:
Long/Short Equity – Takes long and short positions in common stocks to try and make an absolute profit or beat an equity benchmark.
Sector Funds – Specializes in common stocks in one sector and may use long and short positions.
Distressed Securities – Specializes in equity or debt of companies available at a discount due to bankruptcy concerns.
Merger Arbitrage – Focuses on opportunities to buy or sell shares of companies involved in an acquisition.
Activist – Takes large positions in a company and attempts to influence management in a way they believe will increase shareholder value.
Volatility Arbitrage – Bets on the direction of the implied volatility of a security rather than its price movement.
Global Macro – Invests in a wide range of assets to try and earn a steady rate of return. Can be long only or use short positions.

There are a bunch of other structures as well, but this gives a good idea of what hedge funds are focused on. Another key function of the structure of hedge funds is they often, but not always, utilize leverage. For example, a profitable strategy in 2009 and early 2010 would have been to be long German bonds and short Spanish and Greek bonds. The problem is the profits would have been modest, less than stock market returns for the year. To make things more exciting, a fund with $10 million in assets could arrange with their “prime broker” (basically a major broker who can provide more sophisticated services than most people require) to short $50 million of the Spanish and Greek bonds. These proceeds can then be used to buy the German bonds. Now each 1% price move favoring the German bonds would earn $500,000 instead of just $100,000. Leverage can help hedge funds exploit small pricing inefficiencies, but it must be used with caution because an unexpectedly large move in the wrong direction can have catastrophic results. This is what happened to the now infamous Long Term Capital Management in 1998.

A unique feature of hedge funds is they usually charge a set fee for assets under management and another fee for performance. The historical standard was “Two and Twenty”, which meant every year they got 2% of the value of the fund and then they also took twenty percent of the profit above the previous high. So if a hundred million dollar fund made twenty percent, the fee would be two million plus twenty percent of twenty million, for a total of six million. You can see what happens if the numbers start to be bigger and/or there is a year with really big returns. Lately, investors have begun to realize these fees are rarely justified and fees have begun to drop.

Hedge funds are available only to wealthy investors or institutional investors who acknowledge the risks they are taking. Mostly because of this, hedge funds are lightly regulated and are not required to disclose holdings or performance information.

Investors can withdraw money from hedge funds, but usually only with a meaningful advance notice. Even then, penalties may be applied.

Who Should Invest in Hedge Funds?

Hedge Funds have a useful role for institutional investors because they are lowly correlated with stocks and bonds. Individuals with more than $5,000,000 or so may which to allocate some money to one or more hedge funds, but except in rare cases, the total amount should not be more than a 15% allocation. Even then, it is only advisable if they are in a position to properly analyze the funds under consideration. As Bernie Madoff proved, even a seemingly safe hedge fund can be riskier than more common investments. Also, it is difficult to get diversification among hedge funds

Attempts are being made to create hedge fund indexes which can be tracked with funds or ETFs. At this point, I do not believe these are viable products. Funds of funds, while legitimate, add another layer of fees on top of already high fees and are almost never worth it.

Due to the current structure of the industry, most people are simply better off ignoring hedge funds.

How Does One Make Money With Hedge Funds?

When you invest in a hedge fund, you give them money to invest. If their efforts are successful, you can redeem your interest in the fund for a higher price. It depends on what the fund is investing in, but usually these gains are considered capital gains and taxed accordingly.

Historical Experience and What to Expect:

Hedge fund performance is not regulated and it is impossible to really know what it has been. If you believe the commonly quoted hedge fund index numbers, then they are very good and everyone should have a lot of their money in hedge funds. Personally, I don’t. There are a lot of difficulties in calculating these indexes, but theoretically, I find the high numbers hard to believe. Hedge funds are investing partly in ownership of assets that should appreciate over time (like stocks) and partly in trading against price movements in assets in which one side of the trade must win and the other must lose. It seems strange that on average, everyone is winning so much. It is true that hedge funds can leverage and this may allow them to get better returns over time, but I just don’t trust the numbers. Maybe I am paranoid and wrong.

One other aspect of this is that hedge fund holdings are often illiquid. We saw in 2008 what happens when a significant number of investors want to take their money out – it was not possible to raise the funds without severely damaging the market price of the assets. By the way, when most funds report performance, it is based on the asset values they provide. The higher the values, the higher the compensation.

If you want to see the extreme example, look no further than Amaranth Advisors. The hedge fund, managed largely by a Canadian trader named Brian Hunter, was making extremely large bets on the spreads of futures contracts on natural gas. When these bets went well in 2005, the fund performed very well and Mr. Hunter was paid tens of millions of dollars. Similar leveraged bets went badly in 2006 and the fund was essentially wiped out. Investors got back only pennies on the dollar.

Because of the massive compensation awarded to successful hedge fund managers, and I do mean massive, the industry has attracted most of the very best and brightest investment minds. I am usually of the opinion that it is nearly impossible to tell the difference between good managers and lucky managers. But some, like Jim Simons of Renaissance Technologies hedge funds, have posted such incredible returns that, unless they prove to be fraudulent, are statistically beyond the realm of luck. However, the compensation potential has also attracted thousands of people who are not so skilled.

It is impossible to generalize about hedge fund performance because they are all unique. This is just an educated guess, but looking ahead, one should expect hedge fund performance overall to be about what it is supposed to be – a bit better than inflation with less volatility than a long-only stock portfolio. If investors don’t get eaten up by fees, this is pretty good.

Benefits:
Lowly correlated with other asset classes
Potential for high returns

Cons:
Relatively illiquid
Unpredictable
High fees
Difficult to diversify

Collectibles

I am not going to spend much time on collectibles other than to provide some personal history with my baseball card collection. I “invested” a significant portion of the funds available to me as a kid in baseball cards. At one point, on paper, they were probably worth about 300% more than I paid for them. Today, many years later, I could probably sell the lot of them for about 30% of what I paid. Not a great investment, especially after inflation. But I am still glad I have some of the cards.

Buy collectibles if you want to own them, not to make money. If you make some money, consider it a bonus. This goes for wine, cars, art, Beanie Babies, and all other collectibles.

Updated: 5/19/2014

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Craig Birk, CFP®

Craig Birk, CFP®

Craig Birk is a member of the Personal Capital Advisors Investment Committee. He also serves as Vice President of Portfolio Management. Prior to Personal Capital Advisors, he was an integral leader within the portfolio management team at Fisher Investments. During Craig’s time there, the company increased assets under management from $1.5 billion under management to over $40 billion. His responsibilities included risk management, portfolio implementation oversight, and management of all securities and capital markets research analysts. Mr. Birk graduated from the University of California at San Diego and has earned the Certified Financial Planner® designation.

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Disclaimer. This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.