Exploring the investment universe
We begin by dividing the investment universe into two 'galaxies'. The first galaxy contains core assets that play a major role in most investors’ strategies. Everything else is situated in the second galaxy of satellite assets.
Core assets are also called primary or traditional asset classes. The assets that the majority of investors focus on are in this category. These include:
- Equities (shares)
- Bonds (fixed interest)
- Trending globalisation of markets
- Cash (which usually includes short-term money market instruments)
The above three asset classes are very different from one another, but there are very good reasons why they are grouped together.
In essence, these classes are dependable. We know a lot about them and feel confident using them. Their behaviour might sometimes be erratic over short periods, especially equities and longerdated bonds. But over longer periods they usually end up following the same well-known rules:
- Equity returns bounce around more than bond returns over short periods, while bonds tend to vary more than cash returns. Investment professionals refer to this ‘bouncing’ as ‘volatility’ or ‘risk’.
- To fairly compensate investors, longer-term returns are expected to be better for bouncier rides and more uncertain outcomes. This means that equity returns should out-pace bond returns over longer periods, and bond returns should beat cash.
- The additional return investors receive to repay them for the risks they take is called the 'risk premium'. No rational person would endure a rocky ride without the expectation of a pay-off at the end.
There are other reasons why we feel confident using core assets.
- Pricing and valuation – core investments can be traded freely in the markets. Buying and selling prices are automatically updated and can be obtained easily.
- Good data – past statistics on core investment returns can be readily analysed to help us understand their behaviour. This facilitates the analysis of performance.
- Markets that ‘know’ – the prices of investments traded in the bond, equity and cash markets reflect all the information we have on them, i.e. markets are highly efficient.
- Liquidity – we can buy and sell all or part of our investments quickly and at low cost.
- Benchmarks – reliable indicators of how the market is doing can be used to see how the performance of our investment measures up.
- Security and transparency – the investments are protected by well-established regulations. While these protections are not foolproof, they are designed to maximise transparency, efficiency and confidence in the markets.
If these qualities sound good to you, then you think in the same way as most prudent investors. Many investors invest only in core assets.
Satellite assets are also known as secondary or alternative assets. They attract less attention because investors feel less confident about committing money to them. They are less dependable for some or all of the following reasons:
- They have a short track-record
- The information available on them, can be incomplete or of poor quality
- They may not clearly priced or are difficult for investors to value
- They require business skills to own or manage
Three satellite classes most investors have heard about recently are:
- Hedge funds
- Private equity
- Unlisted assets
But there are lots of other satellites. Some can arguably be considered as sub-classes of the three core assets listed above. In a space as diverse and complex as the investment universe, the boundaries can blur.
The following categories of assets can also be classed as satellites:
- Factor portfolios
- ‘Hybrids’ such as convertibles and preference shares
- High yield, mezzanine and unusual debt instruments
- Private debt
Are satellites for me?
The extent to which investors delve into satellites depends largely on:
- Their risk preferences
- The information available to them
- The level of understanding on these investment assets
Historically, many investors have been careful to avoid secondary assets. However, others invest heavily in such assets. Also, the investment industry is constantly evolving, potentially more attractive opportunities appear every day. If you are going to invest in satellite assets, be sure to investigate them thoroughly and understand the risks and rewards of each within the context of your personal risk appetite. Your financial professional is there to provide guidance at every stage of the decision process.