Guide to investing: Part 1 - What are the 7 main asset classes?
Tuesday 24th August, 2021
"What is an investment asset class?"
This is one of the many questions I get asked by friends and prospective clients around the basic fundamentals of investing.
Many people are keen to invest, but often find themselves adrift in a flood of jargon and concepts that seem to make absolutely no sense. I have therefore put together a two part series of articles that look to explain some of the basic concepts that are crucial to understand, before taking the leap into actually investing your money.
In the first part we will look at the building blocks that make up an investment portfolio: the asset classes. We will look at each asset class and discuss what it is and how it works. We will look at the advantages and disadvantages of each and how they can be used to build a well diversified portfolio.
In part 2, I will look at asset allocation and diversification and how to build a portfolio that is suitable for you and what you are looking to achieve.
I really believe that if more people understood these concepts, there would be far more individuals reaping the potentially life changing benefits of a well structured investment portfolio. More importantly, there would be far fewer new investors being taken in by the dishonest snake-oil salesmen who peddle investment scams around the world.
If you are interested in investing, but would still like some help putting together a well balanced portfolio, then please don't hesitate to give us a call.
There are some people who absolutely love investing and pouring over investment strategies, and there are other people who would rather chew through their own arm than have to spend an afternoon analysing a company, fund or portfolio to see if it is any good.
I am an investment nerd and therefore fall into the first category. The idea of generating returns by finding a great investment opportunity really floats my boat. I am almost evangelical about the difference a good long term investment strategy can make to a person’s future.
If you invest properly, with a decent strategy, you can retire early, have that dream home and send your children to university. Investing wisely and with a goal, can make all the difference in the world to your future, as well as the future of your loved ones.
Now, it is important to note that when I talk about investing, I don’t mean speculating. I am not talking about taking a massive short position against the US Dollar, because there is a 50/50 chance that it might fall against Stirling. I certainly don’t mean putting all your money into the latest cryptocurrency to come out of Eastern Europe, because some bloke driving a Ferrari on YouTube told you it is guaranteed to go up by 1000% in the next month.
Rather, I am referring to proper grind it out, long-term investing over 10 – 20 years with 4%-5% annualised returns. I am talking about the old adage of buy quality and hold for the long term. This isn’t easy money. It is putting together an investment strategy and sticking to it, when every fibre of your being is telling you to do the opposite.
This is not putting all your eggs in one basket, in the thin hope that it will go stratospheric. Rather, it is spreading your investments strategically, biding your time and controlling the controllable in a way that history tells us should provide the reasonable returns you need to make your goals a reality.
You may look at that and say, “Well 5% per annum is nothing. I read about a guy who invested in Bitcoin and turned £2,000 into £200,000 over a few years. That’s what I want!”
Now, I can’t deny that it is possible for that to happen. I had an acquaintance who did something similar with ASOS shares. Similarly, I worked at Barclays Wealth, where we had a client who became a multi-millionaire by going long on Bitcoin. However, the problem with human nature is that it tries to make a rule out of the exception. The majority of people who take a punt on a new company take a powder. Rather than watch the share price soar like an eagle, they watch it burrow down like a homesick mole.
However, if you are patient and use a scientific investment approach, riding out the storms and holding your positions, you will probably end up with a lot more money than if you had taken a punt on a few random stocks that a friend recommended to you in the pub.
A case in point is a client I saw yesterday who had set up a pension in 1989. Over time she invested £29,000 into it. She then forgot about it completely, only for it to resurface when she started looking at retirement options. She opened her statement, expecting a negligible amount, only to find that it is now worth £133,000. That is an annualised return of approximately 4.88%. She was only invested in a single basic multi-asset fund. She never changed it once over the time she held the pension. The fund’s Annual Management Charge was a paltry 0.18% per annum. The point I am making is that she bought a fund, which was notionally well diversified, and left it for the long term. The return relative to the markets over that period isn’t actually great, so can you imagine what she could have achieved if she had actually taken an interest?
The point I am trying to drive home through all of this is that, with speculating, the majority of people fail. We have been conditioned by films like “Wallstreet” to think of successful investors as the slick people in flash suits who take massive risks based on their gut and a devil may-care attitude. Our culture has somehow lionised these people, who in reality very seldom achieve much. Whereas history tells us that, based purely on long term historical performance, the best investors are people like Warren Buffet, Peter Lynch and Benjamin Graham. These were not one hit wonders and they all believe in the benefits of buying investments with the intention of holding them for the long term. By adopting a patient approach to investing with a well-diversified portfolio, and a specified investment goal, the majority of people can succeed.
The problem is, if you don’t know what assets you can invest in and what a diversified portfolio looks like, you’re pretty much hobbled from the outset.
I have therefore put together a two-part guide to explain these two elements. In part one, I will look at the different asset classes. In part two I will look at diversification and attitude to risk.
As laways, I am trying to simplify what can be quite a complex subject. If you have any questions or concerns, give us a call.
What is an asset class?
Assets are the building blocks of any investment portfolio. If you are looking to invest it is crucial that you understand what these are and how you can use them to build a portfolio.
The definition of an asset is very broad. It can be any item which is owned by an individual or corporation and has economic value or provides future benefit. Some do both. As value is relative and what is valuable for one person may not be valuable to another, the door is left open in terms of what is considered an asset and what isn’t.
An asset can be tangible (like property or machinery) or it can be intangible (like a patent, copyright or brand name).
An asset class therefore refers to a grouping of assets that have comparable features and are subject to the same laws and regulations. When used in relation to investment, an asset class is made up of assets which often behave similarly to one another in the marketplace. For example, shares are regarded as an asset class. We can witness these shares behaving similarly to one another when there is an economic shock which results in investor trust in the stock market being shaken. In these circumstances we can see a lemming-like sell off of shares along with a corresponding drop in value, as witnessed in 2008 and 2019. During these periods there was a worldwide fall in the value of shares on global markets as a result of the 2008 crash and the 2019 Covid pandemic respectively.
Within asset classes there can be further divisions and distinctions. For example, property as an asset class can be further divided into commercial, residential and agricultural property. These different elements of the same asset class will in turn have different cycles and levels of performance. Within these sub-divisions, there will be even further division. As you can see, it can all get quite convoluted.
From an investment perspective, there are 7 main asset classes, when we look at retail investing. These are as follows:
- Cash
- Fixed Interest (corporate and government bonds)
- Equities (shares)
- Property
- Commodities
- Hedge Funds
- Structured products
Some people may ask, “What about collectables as an asset class?”. This would include things such as wines, cars or art. These are definitely an asset class in their own right, but they tend to be collected by individuals as part of a personal passion for the objects being collected. The value of these assets is quite often an ancillary benefit of owning them. I have had many clients over the past few years who have art or vehicle collections worth millions, however they would never consider selling them. The object’s beauty as a work of art or uniqueness of design trumps any monetary value that it may actually have.
I cannot deny that collectables have value, and can be used to diversify a portfolio. However, it is difficult to determine what the value of the item is at a specific point in time and as financial planners, we simply are not qualified to recommend a particular collectable as part of the portfolio. I have therefore decided to leave collectables out of this discussion.
Over the next few paragraphs, I will look at each of these asset classes individually, providing a basic explanation of how each of them works, as well as the risks most commonly associated with them.
Cash
This includes bank deposit accounts and money market instruments. They tend to be fairly low risk investments and therefore have a corresponding low rate of return.
You are probably never going to lose all your capital on a cash investment even if the bank fails. There will normally be some kind of compensation scheme available that will ensure that you get some of your cash back. If you hold money with a UK-authorised bank, building society or credit union that fails, the Financial Services Compensation Scheme (FSCS) will automatically compensate you:
- up to £85,000 per eligible person, per bank, building society or credit union
- up to £170,000 for joint accounts
The easiest way to negate the risk of bank failure is to save across a wide range of different banks, thus ensuring that all your eggs aren’t in one basket. If one bank fails, then you will only lose a small proportion of your original capital.
If you have a large amount of cash, it can become very difficult to individually open a number of different cash accounts and administer them. In these situations, it can be very useful to use a cash account platform that acts as an aggregator of savings accounts offering access to a wide range of different banks. Through a single provider, you can use a secure online platform to open as many deposit accounts with as many different banks as you require, in just a matter of clicks. Everything is accessed and monitored from one system. You will have to pay to utilise this kind of platform and there is normally a minimum deposit required, but for the ease of use and administration, it can often be very worthwhile. These platforms often have access to beneficial rates, which can offset the additional cost of using this kind of solution.
If you are concerned about losing your savings as a result of holding too much with one bank, but don’t want to use a platform, you can always put your savings with National Savings and Investments (NS&I). As the government’s savings bank, they have the backing of HM Treasury, who guarantee 100% of everything you invest in NS&I. This is probably the most comprehensive level of protection you can have.
Your biggest risk with cash deposits is that the post-tax return is seldom greater than the inflation rate. This means that the cost of living is growing faster than the value of your deposited capital, which in turn means that the buying power of the original capital and the income it produces is falling all the time.
I often meet clients who say to me that they just cannot bear taking risk on investments. That is all very well and I do believe that it is important that you feel comfortable with where your money is held. However, many people don’t realise the full impact of inflation. I therefore illustrate it for them.
Imagine the following scenario:
- You invest £100,000 into a 10-year fixed rate deposit account yielding 2% per year after tax (I am aware this is all completely unrealistic, but bear with me)
- Inflation is running at an average of 3% per year for that period
the negative impact this will have on the buying power of your funds is demonstrated in the table below.
As you can see from this table, the real buying power of your money will actually fall during the 10-year period by almost £9,500 (-9.5%) as inflation is increasing at 1% per annum more than the annual return on your investment.
I accept that this is a fairly basic illustration, but it remains a true reflection of the unseen risk to cash investments. Your original capital may well be safe, but its buying power is spiralling down. The impact of this sort of value erosion is far more insidious in a way, because ostensibly the value of the money is going up all the time creating the false impression of growth. It creates an undue sense of security, and the effects creep up on the investor.
Fixed Interest
These are structures that allow you to lend money to companies or governments over a fixed period of time in return for a regular interest payment for the period of the loan. At the redemption date the original capital is paid back to the lender.
The biggest risk with these is the possibility that the borrowing company or government may default on the loan and fail to pay it back. The greater the risk of the company/government defaulting; the higher the yield the bond will pay. You are effectively getting paid danger money for investing with the risky company/government.
A perfect example of this is when the Greek economy was at the edge of collapse during the financial crisis. Greek government 2-year bond yields rose to 15.3% following a downgrading by Standard and Poor’s. When compared with average rates at the time for other European countries of 4%, this high rate clearly reflects the dangerous level of risk the investor would be taking.
There is an erroneous view that Bonds are low risk. As we can see from the above paragraph, the level of risk is entirely down to the financial strength of the institution being invested in.
Aside from the coupon (interest paid), Corporate Bonds and Government Gilts can be bought and sold on an open market. The underlying value of the Bond or Gilt is generally corelated to the interest rate. When interest rates rise, the market value of the Bond or Gilt will fall, as the attractiveness of its fixed rate is reduced. As interest rates fall, the attractiveness of the fixed coupon increases and its market value will increase.
The market value of Bonds and Gilts is also dictated, to an extent, by the performance of equity markets. When shares are performing well, Bonds and Gilts are regarded as less attractive, due to their overall lower growth prospects. However, when equity markets enter a bear phase, we often experience a “flight to safety” where investors move away from shares to the perceived stability and predictable returns of Bonds and Gilts. The increased demand naturally results in the market value of the Bonds and Gilts increasing. This relationship between equity and bond markets in which one variable increases in value, as the other decreases in value; is known as negative or inverse correlation and forms the basis for diversification of asset classes within a portfolio to moderate volatility and risk.
Shares
A share is effectively where the investor buys a portion of a company. The value of the share will increase or fall in line with the financial performance of that company and the demand for the share on the open market.
The share carries with it certain rights for the investor such as the right to share in profits in the form of dividend payments, as well as the right to vote at annual general meetings.
Dividends are very important. Many investors look at a share in terms of the increase in its value on the open market, while forgetting about the benefit of the regular dividend that it pays out. However; the boost to growth provided by reinvested dividends is substantial and not to be sneezed at. Even if the underlying value of the share falls, the company may still provide a dividend. Some companies, known as dividend aristocrats, have provided a constantly rising dividend yield for 25 years or more.
The risk involved in investing in shares is once again down to the nature of the company whose shares you have purchased. Large well-established companies like General Electric or Vodafone will not provide stratospheric growth as they are nearing the limits of their overall growth capacity. However; their stability and high dividend yield paid from their regular profits make them attractive. Smaller, newer companies either in the UK, US or developing countries offer far more growth potential as they are new ventures. However, as they are focussing all the profits towards growth, they are unlikely to offer dividends at all and they will likely be highly volatile as a result of their youth and drive for growth. They are very risky, but when the risk pays off the returns can be like winning the lottery.
Property
Now, when we refer to property as an asset class we normally are talking about commercial property. This includes office space and space in shopping malls. In the past many bank advisers sold this asset class to clients on the basis that it was residential property. Many an investor probably heard the salesman’s battle cry of, “Go on. Everybody needs a place to live. What can go wrong?”
What can go wrong indeed! Commercial property is a very good asset class to use to diversify a portfolio, as it reacts differently to various market stimuli than other asset classes. When rentals are high and markets are booming commercial property offers a very good return, however when everything goes pear-shaped, which will inevitably happen, you cannot simply sell it and move to another asset class. As it is property, it becomes illiquid in a down market and virtually impossible to sell. Rentals fall as companies go out of business or can no longer afford the cost of expensive city office spaces. The only thing the investor can do is sit tight and hope for the market to turn quickly. We have seen examples of this happening during the Covid 19 market crash, where commercial property started looking very unattractive, with so many people working from home. There was a run on the funds, but insufficient liquidity to pay the investors out. The fund managers therefore placed a moratorium on liquidations, with funds closed to further withdrawals. Investors found themselves suddenly stranded in funds, with no option to sell out. Something similar happened after the Brexit Referendum in 2016, and the FCA is now looking at restrictions on property funds, which could require investors to give between 90 – 180 days’ notice before they can withdraw their money.
There are pros and cons to this approach. By having a minimum notice period in place, this will allow fund managers to hold less money in cash to cover potential bulk withdrawal orders, thus resulting in greater levels of investment and greater corresponding returns. However, the flexibility to buy and sell the holdings will be greatly reduced, resulting in difficulty in rebalancing portfolios.
It is important to have some exposure to commercial property in your portfolio to bring a bit of balance, but it needs to be a limited amount, and you have to be happy that you will not be moving it any time soon in a down market.
There are some people who believe that the trend towards working from home means that commercial property is likely to become a dead asset class. However, I would suggest that this is a bit short-sighted. It is important to remember that with increased home working and nesting, there will be increased demand for parcel delivery and also increased online shopping. With increased parcel delivery and online shopping there is a growing need for warehouse space, which also classifies as commercial property. A failure to provide exposure to this growing part of the market would potentially leave a large hole in the client’s asset allocation.
Commodities
Commodities are a unique asset class and for many years portrayals of commodity markets have formulated our views of what investing involves. Afterall, we have probably all seen video footage of the trading floor of the Chicago Mercantile Exchange in the 80’s with mad crowds of traders screaming and fighting to get their quotes filled, as they traded various commodities.
Many of us may not know exactly what a commodity is, but we have heard them referred to in films like “Trading Places” where they frequently talk about trading pork bellies. When I first heard this, I thought to myself, “that must be made up.”
However, I was wrong. Pork bellies are actually a heavily traded commodity.
Now, the reality is that all those trading floors have been digitised and most of us get exposure to commodities via investment funds and Exchange Traded Funds, as opposed to actually going out and buying physical commodities or futures contracts. However, they remain a potentially very useful portfolio diversifier.
So, what are commodities? They are the basic material which go into making many of the finished products that we buy every day. These include: oil, precious metals, wheat, gold, orange juice, coffee and many others.
One of the key things to remember is that commodity prices are cyclical, as demonstrated by the table below (Bank of Canada Review 2016: Commodity Price Supercycles: What Are They and What Lies Ahead?).
This cyclical nature of commodities over the long term, is largely due to changes in supply and demand. For example, the supercycle extending from the mid 1990’s to 2010 in oil and base metals corresponds with legislative changes in China and a massive period of economic growth creating massive demand for oil and base metals.
In addition to this cyclical nature, there is also a lot of short-term volatility. This can be demonstrated when we look at the price of oil over the COVID pandemic. There was a perfect storm of massive oversupply and a sudden lack of demand, which caused the prices to fall substantially.
Now many investors use commodities as a diversifier within their portfolio, but their reasons for doing so may be different. Some use staple commodities like wheat or agricultural products as a defensive hedge against falls in equity prices. The theory is that even if shares fall in value, the world still needs to eat, so prices of these commodities should maintain their value even if they do not rise.
Others prefer to use commodities more as a speculative punt, which might provide a bit more growth to the portfolio.
For those looking to invest tactically, gold might just be a temporary tactical allocation, aimed at offsetting a fall in equities or a fall in the value of a currency. This means that when equity markets fall in value, we can often see a flight to supposedly safe assets like gold and a corresponding spike in their prices. These spikes in value tend to be fairly short lived and when the equity markets turn, investors quickly sell out of the gold and back into equities.
At the end of the day, commodities tend to form a relatively small part of any investor’s portfolio. From experience, exposure tends to hover somewhere between 5% and 10% of the asset allocation.
It’s also important to remember that for many of the historically successful asset allocation strategies of the past, like the 60/40 model (60% equities and 40% bonds), there has been no commodity exposure at all.
From a personal perspective, I remain dubious about the merits of commodities as an alternative asset class. We can often see certain commodities move in line with equities during global economic crashes. It does add a bit of diversification, however, you have to ask what the merits of that diversification are and is it simply overcomplicating things for the average retail investor?
Hedge funds
We have all seen the headlines about star hedge fund managers getting paid multi-million-pound bonuses. We may all have differing views on the morality of these kinds of sums being paid to anybody. However, how many of us actually know what a hedge fund is?
Like so many of the investments retail investors hold, a hedge fund is generally a pooled investment. A number of investors invest within a particular hedge fund and those pooled funds are managed by a fund manager and his team to make returns.
In many ways, that is where the similarity between hedge funds and most unit trusts and OEICs ends.
Firstly, many hedge funds are not regulated by the FCA. The majority are based offshore in order to take advantage of beneficial tax regimes and laxer regulations. The 2015 FCA survey of hedge funds found that 69% of hedge funds were based in the Cayman Islands. As an investment professional I would be pretty concerned about this, due to the lack of regulatory oversight and protection for investors.
Unlike UK regulated unit trusts and OEICs, they are not limited in terms of the strategies and tactics they can use to generate returns. The strategies used include:
- Arbitrage – where they look to take advantage of anomalies in the market to make money. To put it simplistically, the hedge fund is looking for inconsistencies in the pricing of similar assets in order to take advantage of these and make a profit. With these types of transactions, speed is often of the essence and margins are very tight. The opportunity may only exist for a brief window of time and the hedge fund needs to act incredibly quickly to take advantage of it.
- Directional strategies – as the name suggest these are strategies that make a profit based on whether a share goes up in value (known as “going long”) or goes down in value (known as “going short”). This ability to make a profit in bull and bear markets is a real advantage and opens up all sorts of avenues for making profits. Apart from the standard approach of betting whether the share price will go up or down, the fund manager can also take so called, “market neutral” positions where they invest similar amount in an undervalued stock and an overvalued stock. It then becomes theoretically possible for the hedge fund to profit, regardless of the direction in which the market goes.
- Events driven strategies – these are very niche funds that look to make money off of corporate events such as mergers and acquisitions, liquidations and bankruptcies. Once again, the profit is made by exploiting incorrect market assessments of the value of the companies in question.
- Global macro strategies – These are hedge funds that attempt to profit from broad market swings caused by political or economic events. George Soros shorting Sterling in 1992 as Britain left the ERM is a fantastic example of this. The pound proved to be overvalued and plummeted in value and George Soros personally made over $1bn from the trade.
The FCA hedge fund survey found that the majority of hedge funds (23%) favoured a long/short approach to investment, while a further 17% followed a multi-strategy approach, while 16% favoured a global macro investment strategy. This highlights the fairly agnostic view hedge funds take in terms of how they generate their returns.
As you can see, these funds are making money by spotting niche opportunities. It is these niche opportunities that often make them popular as an alternative investment class. Portfolio managers utilise hedge funds set up to perform in bear markets to hedge against a fall in share prices and use hedge funds that focus on arbitrage and events, rather than market movement, to act as alternative asset classes to increase diversification of the portfolio.
These unique strategies and lack of regulatory restraints means that the onus is massively on the hedge fund manager and his team to spot the opportunities and exploit them, in order to generate returns. The margins on some of these transactions are tiny and the skill of the individual fund manager therefore becomes crucial. Therefore, hedge funds are willing to pay huge sums of money to obtain and retain a profitable, star fund manager.
This ability to adopt alternative strategies to generate returns also means that hedge funds have a pretty high closure rate. I have been unable to find information for recent closures, but the Financial Times printed the following figures in 2014, “Most hedge funds fail: their average life span is about five years. Out of an estimated seventy-two hundred hedge funds in existence at the end of 2010, seven hundred and seventy-five failed or closed in 2011, as did eight hundred and seventy-three in 2012, and nine hundred and four in 2013. This implies that, within three years, around a third of all funds disappeared.” (Most hedge funds fail, Dan McCrum, Financial Times, July 2014).
The reason they fail are fairly broad. These include:
- Failure due to poor management
- Under-performance – despite all the hype around star fund managers, the majority of hedge funds simply fail to outperform their benchmark. In 2019 hedge funds managed to return 9% on average, while the S&P 500 returned 32% in the same period (Stephen Van de Wetering, “Why do Hedge Funds Fail?” – April 2020)
- High fees – the traditional fee model for hedge funds is a 2% ongoing fee and a 20% performance fee on profits. Not all follow this approach, but as a general rule, the fees are pretty eye watering. The thing is, nobody minds paying these fees if they are seeing above average returns. However, Market Watch highlighted that from 2009 – 2018 the Eurekahedge Hedge Fund Index was consistently outperformed by the S&P 500, prompting Warren Buffet to take a victory lap, as he won a bet that passives would outperform actively managed hedge funds over a 10 year period (Hedge funds still can’t keep up with the stock market - MarketWatch)
Once again, I can see the merits of holding hedge funds as alternative asset classes. My problem is this: how do you know which is the right one to choose?
It’s that age old question. There are actively managed funds and hedge funds out there that consistently out perform their index, but how do you know which ones they are? How do you know which are going to be the ones to fail and which will succeed? These are important questions, as the fact that many are not regulated by the FCA means that there is little in the way of restitution if you get it wrong. Even if you don’t pick a fund that fails, you don’t want to pick a mediocre or underperforming one, as the fees will hurt whatever performance you do get.
Structured products
Since the 2008 crisis, structured products have been treated a bit like the Frankenstein’s monster of the investment world. This is largely as a result of the large amounts of subprime mortgage debt being rolled up into structured investment products and sold on, before all going dramatically wrong and setting the world economy back several decades. In addition to this, the collapse of counterparties underwriting the structured investments made to retail investors, the miss-selling of structured products as guaranteed, and breaching of structured product barriers as a result in collapses in the underlying markets, left investors out of pocket and wondering what happened.
There was a general view in the aftermath of 2008, that structured products were too complicated for retail investors to understand all the risks involved. In addition to this, they were often too complicated for the advisers selling them to explain.
However, since then the market in structured products has sprung back and they can often provide another avenue for diversifying a portfolio. The greater financial strength of market counterparties due to capital adequacy rules, provides greater protection for investors. There has also been an FCA review of the structured product market in 2016, with a number of changes recommended and regulatory changes to protect investors.
So, what is a structured product? they are a fixed-term investment vehicle that is linked to an index (such as the FTSE 100) or basket of indexes (for example the FTSE 100, S&P 500 and Euro Stoxx 50), or a specific asset, usually with the promise of a return of the original capital and a specified level of return, provided certain criteria are met, such as the index not falling below a certain level during a specified term.
So where does the counterparty risk come into it? Well, the structured product essentially functions as a contract between the investor and the counterparty bank, facilitated by a product provider. The investor lends their money to the counterparty bank for the term of the product and in return the counterparty bank agrees to return the original investment at the end of the term and a certain level of return based on the performance of the underlying index. Now, you can see the potential risk here, can’t you? The investor has loaned money to the counterparty. If the counterparty then defaults, the investor is left out of pocket. That’s why it was such a nightmare for investors when Lehman Brothers collapsed in 2008. Lehman Brothers was the counterparty for 1% of all the structured products in the UK, which may not sound like a lot, but was pretty substantial.
There are a number of different types of structured products. These include:
- Autocalls, which are structured products which can mature before reaching the end of their term, if certain pre-agreed market conditions have been met. So for example, if the FTSE 100 is 6% up at the end of the first year, the autocall feature will be triggered and the investment will mature, paying out the agreed levels of return to the investor. If this is not the case, the investment will continue and may be reassessed against specific criteria at the end of year two and so on
- Income products are market-linked investments that can provide an enhanced level of income
- Growth products are market-linked investments, which look to generate a specific level of growth along with a return of the principle, based on the performance of the underlying assets
- Structured deposit plans are cash-based fixed term deposits which offer a variable return linked to the performance of an underlying asset. These are the only type of investment that provide protection from the Financial Services Compensation Scheme
So why would you use these as part of your portfolio? Well, you may have spotted a trend in all the paragraphs above. The aim is to diversify across different asset classes and outcomes. Therefore, some structured products are designed to provide a return in bear markets. This can be particularly useful in hedging against falls in the market.
Furthermore, some of the investment risk is shifted from the investor to the counterparty, who has to provide the returns agreed if the specified criteria are achieved.
Some argue that in a low growth environment, structured investments could potentially provide better returns for investors. While I am sceptical about this point, I do understand why it is made. From my perspective, low growth markets are relative. People have been talking about low growth markets for most of my career, and we still see reasonable returns for investors who are patient and apply a well thought out investment strategy.
At the end of the day, structured products provide one more string to the investor’s bow to help achieve the returns they require. These will not be for everyone. I have seen both sides of structured products. I have seen investors ecstatic at the performance of their structured investments relative to the market and I have also seen the trauma of investors who took out structured investments without understanding them and took substantial losses.
How and if you use them really depends on your personal views and what you are trying to achieve.
Final thoughts
A key thing to remember in all of this is that as the world evolves, so do asset classes. What was attractive a few months ago, can now be an area of real underperformance. In order to stay on top of this, it is important to constantly be reviewing the markets and trends in different regions, asset classes and industries. For many people this may be very interesting and exciting, but it can also be overwhelming and difficult to keep up with the volume of information. This is where many financial advisors have the edge, with access to data and product innovations that the average individual simply could not afford and may not understand. This allows them to analyse the data and use this to put their clients in portfolios with asset allocations that are most likely to meet their needs.
The asset classes discussed above are the seven main asset types that can go into making up a portfolio. In reality, many portfolios do not contain all of these asset classes, as they are not suitable for the individual investor or will make the portfolio too complex. There are also other options which we have not covered as they are too complicated, too niche or simply are not available to retail investors. In addition to this, we have not covered the ability to use private equity in the form of Venture Capital Trusts and Enterprise Investment Schemes, as satellite investments to provide exposure to start-up companies. As with many things in finance, asset allocation is a complicated area. If you would like to discuss it further, please don’t hesitate to give us a call.