A Look At Asset Classes: What Do They Mean To Investors

Foreword from ShareInvestor

This article “A Look At Asset Classes: What Do They Mean To Investors” by INVEST was first published in the Jun 2010 – Jul 2010 Issue of INVEST magazine and is reproduced in this blog in its entirety. This article introduces you to the various asset classes for portfolio diversification with due regard to the individual’s investment horizon, risk appetite and investment goals.

Most investors and investment professionals given a choice would want a double digit total return in all economic environments, year after year. However, very few achieve the ideal and in fact end up encountering the worst-case scenario of an overall decrease in asset value.

It is important to understand that effective diversification of asset classes is needed for investors to achieve returns that are in tune with performance of the underlying asset class. Many times investors tend to believe they are fully diversified when in reality they have merely invested in multiple sectors of the equities asset class and are prone to the rise and fall with that market.

Ideal asset allocation is not static. As the various markets develop, their varying performance leads to an asset class imbalance, so monitoring and realignment is imperative. Instead of being bogged down with stock picking and trading, investors need to take a broader view and concentrate of asset classes.

As Manoj Agarwal of OptionPundit says, ” Choosing an asset class could be complex yet simple. An investor should choose different asset classes based on:

  1. long/short term portfolio growth goals,
  2. Risk appetite and
  3. knowledge of various financial instruments.

Sometimes, especially with hindsight bias, investors may think I should have invested in “that” asset class. In investing, there is no coulda, woulda, shoulda. If you can confidently invest in the asset class that you know well and which also delivers the goals you are aiming for, there is no need to increase unnecessary risk exposure by investing into asset classes you don’t know about.”

Here we take a close look at the asset classes of CFD, ETFs, Forex, Options and Warrants.

CFDs

Contract for Difference (CFD) is a trade able instrument that mirrors the movements of the asset underlying it. Essentially, it is a contract between the client and the broker. There are several major advantages to trading CFDs and these have resulted in an increased popularity of the instruments over the last several years.

CFDs provide higher leverage than traditional trading, provide global market access from a single platform, most CFD markets do not have any restrictions on short selling, there are no restrictions on day trading and above all there are a variety of trading options with CFDs.

The CFD industry is not highly regulated as a result of which the credibility of the broker is based on reputation, life span and financial position. Also, while stocks expose the trader to fees, more regulation, commissions and higher capital requirements, the CFD market has its own way of trimming profits by way of larger spreads.

In an overall analysis, CFDs provide an excellent alternative for certain types of trades or traders, such as short and long-term investors, but each individual must weigh the costs and benefits and proceed according to what works best within their trading plan.

ETFs

The Exchange Traded Fund is a relatively recent financial invention that has left an indelible impact on the financial markets and created a world of opportunity for retail investors at the same time. In a very basic terminology, the ETFs are like mutual funds that trade like stocks with smaller management expense ratios.

An investor essentially buys a mutual fund to get exposure to a basket of many stocks or sectors because purchasing 15, 20 or more stocks individually doesn’t make sense on a cost basis and require a lot of research.

Equity-based ETFs offer the same advantage, but with superior liquidity. Also Mutual Funds trade at just one price over the course of a trade day and this is their net asset value, while ETFs issue shares to investors and these shares trade like shares of traditional stocks. This makes ETFs an attractive proposition both for long-term investors and short-term traders alike.

An interesting aspect about ETFs is its ability to allow investors to invest in asset classes that they hitherto have not included in their portfolios like commodities, emerging markets and forex. ETFs are easily the best avenue for conservative investors to access securities like gold, oil and currencies beyond the US dollar.

In cost comparison to mutual funds, ETFs are more cost efficient. Their expense ratios rarely traverse 1 %. ETFs even feature lower expenses than many passively managed index funds as well as tax benefits that their mutual fund counterparts can’t match.

In conclusion it may be an understatement to mention that ETFs may be the most important addition to the retain investors’ arsenal in the past several decades. More competition is expected in this area as more investment firms enter the ETF fray and the product offerings evolve further.

Forex

The forex market is the largest market in the world and individuals are becoming increasingly interested in it. But trading in it needs some amount of caution and a right broker. In many aspects, the forex market has comparable similarities to the equity markets.

Choosing a broker can be the most important aspect to investing is this asset class. Hence while selecting a broker one needs to find the difference in spreads that various brokers have to offer. The lower the spread, better is the realisation for the investor. You need to make sure that your broker is backed by a reliable institution because unlike equities, forex brokers are usually tied to large banks or lending institutions because of the large amounts of capital required.

Just like equity markets, technical analysis and fundamental analysis are the two basic genres of strategy in the forex market. Technical analysis is by far the most common strategy used by individual forex traders.

Most successful traders develop a strategy and perfect it over time. Some people focus on one particular study or calculation, while others use broad spectrum analysis to determine their trades. Most experts suggest trying a combination of both fundamental and technical analysis, with which one can make long-term projects and also determine entry and exit points. But in the end, it is the individual trader who needs to decide what works best.

Leverage, expressed as a ratio between total capital available to actual capital, is the amount of money a broker will lend for trading. Leverage is extremely critical in forex because the price deviations – source of profit – are merely fractions of a cent. Hence a ratio of 100:1 means the broker would lend $ 100 for every $ 1 of actual capital. Lower leverage means lower risk, but also lower bank for the buck.

Options

Options have been around for over three decades, but are only now starting to get the attention they deserve. Most investors avoid options believing them to be sophisticated and hence difficult to understand, while many have had initial bad experiences due to lack of knowledge and training in using them.

There are four key advantages that options give an investor :

  1. Have great leveraging power and provide increased cost efficiency
  2. Less risky compared to equities
  3. Have the potential to deliver higher percentage returns
  4. Offer a number of strategic alternatives.

Based on the primary advantages of options, it is no surprise that they are the center of attraction in financial circles today. With online brokerages providing direct access to the options markets through the internet and at insanely low commission costs, the average retail investor now has the ability to use the most powerful tool in the investment industry just the way professionals do.

Warrants

Warrants, like an option, give the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time. However, unlike an option, an instrument of the stock exchange, a warrant is issued by a company. The security represented in the warrant is delivered by the issuing company instead of an investor holding the shares.

Companies will often include warrants as part of a new issue offering to entice investors into buying the new security. A warrant can also increase a shareholder’s confidence in a stock, if the underlying value of the security actually does increase overtime.

There are two different types of warrants: a call warrant and a put warrant. A call warrant represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date. A put warrant represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date.

In conclusion, all too often, private investors become bogged down with stock picking and trading – activities that are not only time consuming, but can be overwhelming. It could be more beneficial – and significantly less resource intensive – to take a broader view and concentrate on asset classes. With this macro view, the investor’s individual investment decisions are simplified, and they may even be more profitable.