07/05/2021

Asset Classes Explained

The ups and downs in financial markets have made many investors uneasy about investing in riskier assets. In such times, it often helps to take a step back and consider each asset class to better understand how it works and what to expect.

The main types of asset classes are shares, property, bonds (or fixed interest as they are often called) and cash.  Within each asset class, there are further asset types. For example, within shares, investors can choose from Australian shares, international shares or within the international shares arena, specific regions or countries like China or emerging market shares.

Investors may sometimes base their investment decision on the historical performance of asset classes although this approach is fraught with danger.

The value of $100 invested in the various asset classes since December 31, 2009 is illustrated below.

Indices used are as follows: Australian shares – S&P/ASX 300 Accumulation Index, International shares – MSCI World Ex Australia Index (net. Div. Reinvested) AUD, Australian fixed interest – S&P/ASX Australian Fixed Interest Index, International fixed interest – S&P Global Leveraged Loan Index AUD TR Hedged (note, index only in place since May 2013. Estimated $120 invested at that point), Listed property (REITs) – S&P/ASX 300 A-REIT Accumulation Index, Cash – RBA Bank Accepted Bills 90 Days. CPI ABS Consumer Price Index

It is paramount that investors understand the different asset classes to ensure they make informed investment decisions.  These different asset classes are explained below.  

Australian shares

Shares represent part ownership in a company. There are different types of shares such as ordinary shares, preference shares or partly-paid (contributing) shares. Owning shares in a company entitles the investor to participate in any dividends paid by the company from its profits. This represents the income return from shares.

Dividends from Australian shares often include tax benefits in the form of franked dividends. Franked dividends are dividends paid by a company out of profits on which the company has already paid tax. The investor is entitled to a franking (imputation) credit, or reduction in the amount of income tax that must be paid, up to the amount of tax already paid by the company. This means that the investor avoids paying tax twice on the profits generated by the company – once by the company and again by the investor at their own tax rate.

Share ownership also exposes the investor to movements in the share price of the company. If the share price increases above the price that it was purchased, the investor will make a capital gain. On the other hand, if the share price falls below the price at which the shares were originally purchased, the investor makes a capital loss. 

The price of shares can be influenced by several factors including the performance of the local and international economies, interest rates, inflation and the magnitude of competition in the industry the companies operate in, as well as investor sentiment.

Share prices tend to fluctuate substantially over short periods of time but over longer periods such as over five and ten years, their returns tend to be more reliable. For this reason, it is often suggested that investors consider share investments only if they are willing to stay invested for at least five years.

The type of company and industry can have a major impact on the performance of the shares. Resource companies that sell commodities to countries including China and India have are affected by movements in commodity prices and have begun to benefit from a rebound in commodity prices in the last year. On the other hand, some industries like banks have benefitted by the search by investors for high yielding investments. The composition by industry of the Australian share market is illustrated in the graph below. It illustrates that almost half of the Australian share market is represented by materials and finance companies.

Source: https://www.marketindex.com.au/asx300

International shares

International shares are shares in companies that are domiciled in a country other than Australia. Investors often spread their money across a range of countries and industries. Like Australian shares, the return from international shares is made up of any dividends received as well as the capital gain or loss resulting from the change in the company’s share price.  International shares are different to Australian shares in several key ways:

• The dividends paid by international shares tend to be lower than those paid by Australian companies and therefore the income return tends to be lower. Also, international shares do not have franking credits and therefore may not be as tax effective as dividends paid from Australian companies.
• International shares offer a far greater range of investment options. International shares offer access to other countries with different economic prospects such as the United States and Europe as well as China and emerging markets. International shares can also provide exposure to industries that may not be well represented in Australia. The greater spread of shares across geographies and industries can result in lower risk to your portfolio because of the diversification.
• The returns of international assets including shares are also affected by changes in the Australian dollar. Generally, if the Australian dollar strengthens, returns from international assets are reduced because the currency movement results in a loss when the international asset is converted back to Australian dollars. However, when the Australian dollar weakens, returns from international assets are increased because of currency gains.

Like Australian shares, the share price movement can be very volatile over short periods of time and it is best to invest in these only if the intention is to stay invested for at least five years.

Property

There are different types of property investments. An investor can purchase a property or number of properties directly in which case they will be benefit from the rent received by the properties as well as the change in the valuation of the property over time. The returns of these properties will be dependent on the quality of the tenant and the rent paid as well as the location and type of property such as residential, industrial or commercial.

An investor can purchase properties directly or via units in a trust that purchases the properties on behalf of investors (these are called unlisted property trusts). Accessing property via a trust often allows the investor the ability to gain exposure to more properties than if they used their investment amount to purchase property themselves. This spread of properties can reduce the overall risk of the property investment.

Investors can also gain exposure to property by buying units in a property trust that is listed on the Stock Exchange (listed REITs). Both unlisted and listed property trusts can borrow money as part of the trust structure and therefore returns to investors will be affected by the borrowings. Borrowing allows the trust to increase their purchases of properties and/or undertake development of properties. Returns to investors are paid after the borrowing costs are repaid. The level of borrowings can also add to the risk of the investment particularly if the valuation of the properties fall or the income generated by the properties is insufficient to pay the interest.  

Bonds (also called fixed interest)

A bond is a tradeable debt security, usually issued by a government, semi-government or corporate body to raise money. Investors in the bond have lent money for which they receive a fixed rate of interest over a set period. The bond is repaid with interest on the predetermined maturity date. Some bonds can be traded on the share market.

The returns from bonds are based on the fixed rate of interest paid over the term. If the bond is traded the price will be affected by changes to market interest rates.  If market interest rates rise, the price of the bond will fall and the investor will have a capital loss which reduces their total return. Conversely if market interest rates fall, the value of the bond will increase meaning that there will be a capital gain that adds to the overall return from the investment.

Cash

Cash is one of the safest investments. It includes cash in the bank, cash management trusts and even cash in your pocket.  Cash returns are based on the official cash or interest rate which is set by the Reserve Bank of Australia as part of its monetary policy. The Reserve Bank changes the official interest rate to attempt to control inflation.

Putting it all together

The right investment depends on the individual investor and their needs and circumstances. There are several things that each investor must consider such as their investment time horizon (how long can the money be invested), the level of returns sought and the amount of risk the investor is willing to accept. Investors would be wise to combine asset classes in their portfolio to achieve diversification (that is, not putting all eggs in one basket).

It should be remembered that past returns are not a good indicator of future returns and therefore decisions on which asset class to invest in should not be based on historical performance.