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Jargon Buster: Asset Classes Made Easy

15/07/2020

When navigating the world of investment, you can be confronted by a wave of jargon and it’s easy to come adrift. Our simple guide explains some of the key asset classes.

Equities: An equity investment represents an ownership interest in a company. In order to raise capital, companies may decide to sell shares to investors. In buying a share the investor has part ownership of that company. 

Most companies in which investors can buy shares are listed on the stock exchange. The value of a share is reflected in its daily price which moves according to the supply and demand for that share in the market. The daily influx of data causes shares to change price – the market is almost like a beehive of people trying to decide what value they place on a company. As the future is unknown, opinions are varied – and equity prices tend to move around accordingly. 

A company rewards its investors by issuing dividends to its shareholders from its profits, usually on an annual basis. However, it is important to note that companies do not have to issue dividends

A company may also be involved in share buybacks – this is when a company buys back some of its own shares. It reduces the number of shares on the market and generally raises their price. 

This asset class typically gives a higher return in portfolios, but subsequently involves more risk. The value of your holdings can increase if the shares you own become worth more than what you paid for them. At the same time, investors risk bearing losses in the event that the company performs poorly and the value of the shares fall. If a company becomes bankrupt, investors can lose all of the money they had invested in it. 

Bonds: In contrast to equities, bonds do not give investors a share in a company. Rather, investors loan money to a borrower (typically governments or companies) and in return receive regular interest (coupon). At the end of a fixed-term, investors receive the capital they initially invested (principal).

Bonds are issued by states, sovereign governments and companies to finance projects. 

Bonds are rated on their quality by various different rating agencies, from a high of “AAA” (highly unlikely to default) through to a low of “D” (already in default).

The rating is based on factors including the issuer’s reputation, management, debts and its records in paying interest. Imagine you were lending money to some friends – who would be most likely to pay it back? If your friend has a history of not doing so, they would receive a low rating.

The creditworthiness of the issuer affects the amount of coupon investors receive. For example, if you hold a bond issued by the UK government (federal bond), the risk of default is very low and you will receive very little coupon.

On the whole, bonds are generally less risky than equities. They also tend to trade in opposite directions to equities, that is to say they are negatively correlated. Investors hold bonds to help increase the diversification benefits of their portfolio. If equities fall, bonds tend to increase in value and vice-versa. 

Alternatives

Alternatives are other types of investments that have different characteristics to traditional equities and bonds.  Examples of alternative investment are outlined below:

Private Equity: This involves investing directly in companies with growth potential which are not listed on a  public investment exchange, such as the London Stock Exchange. Investments in private equity should be considered as illiquid because withdrawing invested capital can be difficult or, at times, impossible. Unlike with publicly listed companies, there is no order book to match buyers and sellers. These investments should be considered as long term i.e. they should be held for between 5 to 8 years. 

Hedge Funds: Hedge funds employ a variety of strategies in order to generate absolute return in all market conditions. Absolute return is the percent amount that an asset rises or declines in value in a given period.  These funds  “hedge” the markets – their strategies are designed to generate returns when markets are both rising and falling. Nonetheless, hedge funds carry no guaranteed return of invested capital, which, under certain circumstances, may lead to the loss of your entire investment. 

Hedge funds tend to employ a different fee structure known as 2 and 20 – they generally charge a 2% management fee, plus 20% of the profits that they generate. For example, if you invested £100,000 and the hedge fund made 5% profit, you would be charged £2,000 management fee and £1,600 fee on the profit achieved. This figure does not represent any particular fund and the figures are for illustrative purposes only.  A profit of any investment in a hedge fund is not guaranteed and may not be achieved.

Commodities: These are products which are mostly used as inputs in the production of other goods and services. Examples include gold, barrels of oil and wheat.

Many commodities trade on a commodities exchange, in which they are bought and sold in a similar manner to equities.  However, there is a difference – when a trade is executed, the commodities contract is standardized, fixing a price and future delivery date for the commodity being traded. Regardless of the current price of the commodity on the delivery date, it is bought for the fixed price agreed at the trade execution date.

Some commodities have safe-haven properties, such as gold. Many investors hold gold, as it  tends to outperform if there is a sell-off in the markets. 

Real Estate: Adding real estate to a portfolio can reduce volatility, as it often has a low correlation with other asset classes. However, much like Private Equity, this too can be a highly illiquid asset class. The underlying holdings often include various types of properties which cannot be sold quickly. 

Cryptocurrencies: Cryptocurrencies are digital money, which means the currency only exists online and is not controlled by a bank, treasury or country. There are no physical coins or notes. 

Cryptocurrencies  are designed to function as a medium of exchange – they are limited entries in a database that no one can change without fulfilling specific conditions. Cryptotechnology is used to secure and verify transactions, as well as control the creation of new units of a particular cryptocurrency.

As these are de-centralised currencies, they can lack true underlying value and are considered particularly risky for most investors. When investing in other asset classes, some form of data can help guide your decisions – for example company earnings, property prices, credit rating… When investing in cryptocurrencies, the underlying value is much less clear.

Bitcoin is the most famous cryptocurrency, but there are more than 1,500 cryptocurrencies including Ethereum and Litecoin. Many legitimate businesses accept cryptocurrencies as payment.

Quick transaction times is one of the reasons cryptocurrencies are popular amongst some people. However, they also allow you to pay for or sell something anonymously, which makes them a target for scammers. The Financial Conduct Authority, by whom firms are regulated to undertake investment business in the UK, has issued a warning with regard to coronavirus-related crypto scams. It also has a warning list so that you can check if you are dealing with a known scam:

www.coindesk.com/uk-financial-regulator-watch-out-for-coronavirus-crypto-scams

Kleinwort Hambros does not offer investments in cryptocurrencies.

CA180/JUL/2020