What are asset classes?
In this series, we explain what asset classes are, how each one is affected by economic conditions, how funds have moved between asset classes over the past week and month, and the future outlook.
Investors, both institutional and retail, invest their funds in variety of investment avenues known as asset classes. The investment avenues are differentiated into separate asset classes, as each of them has a risk-return profile and different characteristics, so they perform differently in different market conditions. The following are the major asset classes investors put their money into:
Our focus in this series will be the first two asset classes, as they’re the most traded options.
In simple terms, “equity” refers to the shares of corporations. Shares, also known as “common stock,” give investors ownership in corporations. The equity holders’ right on the corporation’s assets is subordinate to lenders’ rights, making equity investments riskier than debt. In good times, equities outperform debt as the operating performance (revenues and profitability) of corporations improve, leaving higher residual income (after interest and principal payment to debt holders) to be distributed among the equity holders. In bad times, the residual income stream contracts, leaving fewer proceeds to be distributed among shareholders. As the stocks are valued by either discounting expected future cash flows or dividends or by using relative valuation techniques, the operating performance, leaving other things constant, drives the performance of the stock.
The corporations are further divided among large cap, mid cap, or small cap, depending on their size. Examples of large cap, mid cap, and small cap include Apple Inc. (AAPL), United Rentals (UR), and First Source Corporation Inc. (SRCE).
Investors can directly invest in stocks for primary or secondary markets or invest in ETFs such as SPDR S&P 500 ETF TRUST (SPY). SPY seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500 Index. Investors can also invest in geography-focused funds such as iShares MSCI Japan ETF (EWJ) or sector-specific funds such as the Energy Sector SPDR Fund (XLE). Investments in ETFs offer numerous benefits, such as sophisticated investment management and diversification.
To learn more about other asset classes, read on to Part 2 of this series.