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In our previous newsletter, we discussed broad opportunities like the MSCI World Index. But are there investments better suited to your goals and risk appetite? Before answering that, let’s delve into the foundation of investing: asset classes and financial products. Financial products are often called securities when they represent the ownership of some underlying asset. These instruments, among which stocks and bonds that I am sure you heard of before, represent different ways to allocate capital to achieve financial growth or stability.

Instruments that share similar characteristics, behave similarly in the market, and are subject to similar laws and regulations can be grouped into an asset class. There are many types of asset classes. Each asset class puts your money to work in a different way, provides different returns, and exposes you to different levels of risk.

Whilst understanding that this may not come out as the most exciting of our newsletters, Antonio and I still deem it crucial for making you a good long-term quality investor. Below, we explore the major asset classes and their characteristics.

Cash and Cash Equivalents

Cash and cash equivalents represent the most liquid assets in an investor's portfolio. These assets, easily convertible into cash with minimal risk of loss, are crucial for maintaining financial stability and seizing investment opportunities. Examples include current accounts, savings accounts, time deposits and money market funds. Cash and cash equivalents are generally considered to be the lowest-risk asset class, but they also have the lowest potential returns. 

While the risk of directly losing your money for market movements is low, the longer the period the higher the chance you may end up losing money indirectly. For instance, one has to consider: (i) inflation risk, when inflation erodes the purchasing power of cash over time; (ii) interest rate risk, caused by the changes in interest rates that can affect the value of cash equivalents; (iii) credit risk, although minimal, when there's a slight risk of default on some cash equivalents, such as our commercial paper.

Bonds

Bonds are debt securities that offer investors a way to lend money to governments and corporations in exchange for regular interest payments (known as “coupons") and the return of your initial investment (the “principal”) when the bond matures. There are also so-called zero-coupon bonds (i.e. without a coupon), where the return is given by the difference of the bond’s price and the face value.

There are some key terms you may hear associated with bonds; for your knowledge we re summarising the main ones below:

• Face Value: the amount the issuer promises to repay the bondholder at maturity.

• Coupon Rate: the interest rate the issuer pays to the bondholder, usually expressed as a percentage of the face value.

• Maturity Date: The date when the bond reaches maturity and the issuer repays the face value to the bondholder.

• Yield: The effective rate of return on a bond, considering the purchase price, coupon payments, and time to maturity.

• Rating: Assessment of the creditworthiness of a bond issuer, based on their ability to repay debt and meet financial obligations. 

Bonds prices tend to converge to their face value getting closer to maturity (as you will get back that amount by then), but during interim periods their price may fluctuate based on inflation, central banks’ rates, credit worthiness, and liquidity, which then constitute bonds’ main risks.

Equity

Equities, also known as stocks or shares, represent ownership in a company and constitute one of the most prominent asset classes in the investment landscape. When you buy a stock, you become a shareholder in the company and are entitled to a portion of its assets, liabilities and earnings. Each share represents a fractional ownership stake, and shareholders may benefit through capital appreciation and dividends. Equities are traded on public stock exchanges, such as the New York Stock Exchange (NYSE), Nasdaq, Euronext, London Stock Exchange and Tokyo Stock Exchange.

Equities are inherently volatile due to their sensitivity to company performance, economic conditions and investor sentiment. Despite short-term fluctuations, equities have historically outperformed other asset classes over extended periods, making them a central component of long-term investment strategies. Furthermore, despite short-term fluctuations, long-term stock prices are deeply related to the underlying performance of the company, as represented by its earnings. 

Therefore, stocks do provide potential higher returns, but without any guaranteed cash flows. Furthermore, should the company you invest in lose its customers (and therefore its revenues and earnings) you may lose your money and ultimately lose it all should the company go bankrupt. As the asset class we mostly invest in we will further comment on it in the coming newsletters.

Currencies

Currencies, also known as foreign exchange or forex, are a unique and critical asset class within the global financial markets. Unlike traditional asset classes such as equities, bonds, or real estate, currencies are traded in pairs and derive their value relative to one another (e.g. the EUR/USD (Euro/US Dollar) or GBP/JPY (British Pound/Japanese Yen). As the value of one currency is expressed relative to another, making forex a zero-sum market; gains in one currency imply losses in the counterpart. They serve multiple purposes in the financial ecosystem, including facilitating international trade, serving as a store of value, and acting as a medium for speculative investment.

Unlike equities or real estate, currencies do not represent ownership of a tangible or intangible asset. Instead, they are traded for their potential to appreciate or depreciate relative to another currency. A common use for investors of the FX market would be to purchase a foreign currency to then buy a security denominated in that currency. For instance, Halma plc is a British company denominated in GBp; to purchase it you may need to get GBp first depending on your broker.

Commodities

Commodities encompass physical goods and natural resources that are essential to economic activity. From crude oil and gold to agricultural products and industrial metals, commodities are diverse and serve as vital components of global trade, investment, and production. One may recall the frozen orange juice traded in the movie Trading Places:

The main difference between commodities and other asset classes is that their price does not depend on their underlying value, but on demand and supply. Notable mentions are gold and oil / natural gas.

Alternative Investments

Alternative investments are non-traditional asset classes that do not fit into the above categories. Examples include hedge funds, private equity, and cryptocurrencies. Alternative investments can be higher-risk than traditional asset classes, but they can also offer the potential for higher returns.

Hedge Funds are investment funds that use a variety of strategies to generate returns, including long/short equity, arbitrage, and macro strategies. Hedge funds are typically only available to professional investors and can be illiquid.

Private Equity involves investing in privately held companies that are not publicly traded. This can include venture capital (investing in early-stage companies) and buyouts (acquiring controlling stakes in established companies). Private equity investments are typically illiquid and have a long-term investment horizon.

Other Alternative Investments include collectibles (art, antiques, etc.), which can be difficult to value and illiquid.

Real Estate

Investing in real estate involves owning physical property, such as land or buildings. Real estate can provide income through rent and appreciate in value over time. There are two main ways to invest in real estate:

• Direct Ownership: Involves buying physical property, which requires significant capital and management effort.

• Real Estate Investment Trusts (REITs): Are companies that own and operate income-producing real estate. REITs offer a more liquid way to invest in real estate.

Real estate is tangible and  highly heterogeneous; no two properties are exactly alike due to differences in location, design, and functionality. These characteristics distinguish real estate from other asset classes, such as equities or bonds, which are more standardized and easily traded.

In many countries real estate still is the main source of wealth for most households, either because it’s a much needed investment (you need a roof over your head) or because of lack of trust / knowledge in other asset classes.

Surely real estate provides inflation protection, rental income, easy access to leverage, but it also has a few disadvantages, such as illiquidity, high entry costs, management intensity (time consuming if you do it yourself),concentration risk (often in the same place), market risk (yes, prices can go down too), tenant risk, interest rate risk.

Beyond Asset Classes

While not asset classes themselves, these instruments span multiple asset classes:

ETFs or Exchange-Traded Funds (ETFs) are a type of investment funds that are traded on stock exchanges, similar to individual stocks. ETFs hold a collection of underlying assets, which can include stocks, bonds, commodities, or other securities often organized around a strategy, theme, exposure, or replicating a financial index (e.g. the MSCI World).

Derivatives are financial instruments representing contracts whose value is derived from an underlying asset, such as stocks, bonds, or commodities. Examples include options ( agreements that give the right but not the obligation to buy/sell something at a certain price and date) and forward/futures contracts ( agreement that gives the obligations to buy/sell something at a certain price and date). They are often used for hedging risk or speculative purposes, and they require a deeper understanding of market dynamics.

Other Funds. There are other collective investment schemes available for investors, such as money market funds, pension funds… Similarly to Hedge Funds, these are pools of money from different investors utilised to purchase assets: the name usually implies their investment strategy.

Recap Table: Characteristics of Asset Classes

To recap, you can find below the main characteristics of each asset class. In particular, please note that the liquidity represents how easy it is to buy/sell that financial instrument, whilst volatility represents whether the prices of that asset class fluctuate a lot.

After these initial newsletters, mostly needed to start from the basics, next week we will have two articles that will finally discuss our vision both theoretical and practical on investing: 

• On Tuesday we will share our investment philosophy, explaining how we buy and (rarely) sell securities;

• on Thursday for our Partners we will discuss our January’s trades. 

See you in your inbox (and on yain.eu)!