The different asset classes

The investment universe can be split across investment assets into four classes or categories:

• Defensive or income assets,
• Growth assets,
• Defensive growth assets, and
• Alternative assets.

Each asset class has different income and risk characteristics. The secret is to blend them depending on your tolerance to risk or what stage your SMSF is in.

Defensive or income assets

Defensive investments are meant to produce income without too much if any fluctuation in their value. They include fixed interest, such as government and corporate bonds, term deposits, mortgages, first mortgages and cash. The reason they are called defensive is because most investors believe that the value of the investment is secure. The truth is some fixed interest investments can decrease in value just like growth investments.

An example of this is government or corporate bonds. In many cases these investments are for a fixed term at a fixed rate of interest. In times of rising interest rates the underlying value of the investment can decrease. If an investor is forced to sell one of these before it matures they can suffer a loss. Conversely when interest rates are falling the underlying value of an investment with a fixed high rate of return will be greater than new investments at a lower interest rate, and they can be sold at a profit.

In addition to the value of one of these investments decreasing because of rising interest rates, investors can also suffer a loss when the borrower defaults and the underlying value of the asset is less than the loan value.  

Investing into this asset class can either be done directly, such as taking out a term deposit or investing directly into a first mortgage, or it can also be done through a unitised investment via listed and unlisted trusts.

There have been several much publicised collapses of mortgage funds in recent years but there are some pooled mortgaged funds that have been around for more than 30 years, have survived the GFC, never missed an income payment to investors, and even in this low interest rate environment produce returns well in excess of term deposit rates.

In addition there are index funds available that buy up the investments making up an index. Examples of these in the fixed interest area are the UBS Australian Composite Bond Index and the Barclays Capital Global Aggregate Ex Securitised Index.

Growth assets

Growth assets are expected to produce some income but most of the return should come from an increase in their value. The value of these investments is often dictated by the principles of supply and demand.

This can come from being listed on some sort of exchange, such as shares, or can come from an open market such as is the case with property. A feature of this investment class is that the underlying value of an investment is not always reflected in its market value.

The secret when investing in growth assets is to not get caught in the hype of whatever is driving a particular market. Instead it is important to retain a clear head and make decisions based on your long term goals.

As Warren Buffet puts it, “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it”. Putting it another way, when a market crashes it is best not to jump off the cliff with the other lemmings and sell in panic, it is a lot better to be the hawk spotting and buying undervalued investments.

Growth assets are predominantly shares in companies listed on the Australian share and overseas share markets. Taking Australian shares first there are basically three ways of investing in them:

• Direct share investment,
• Through an actively managed fund or SMA, and
• Through an index fund.

Direct share investment

Investing directly into the share market can be very rewarding when the companies purchased are held for the long-term. During the recent share market boom that preceded the GFC many investors became day traders buying and selling shares regularly. When a market is rising it is not too difficult to make a profit doing this. Unfortunately, as many investors learnt, when a market crashes this approach can lead to major losses.

Whatever system you decide to use when directly investing in listed shares, whether it is following a share brokers recommendations, subscribing to one of the more reputable share investment reporting services, or from doing your own research, the important thing to remember it is best if you diversify your investment over a number of listed companies that are held for the long-term.

Managed funds

An alternative to investing directly in the share market is to use a managed fund. Managed share funds are split into two types, unlisted managed funds and listed funds known as Electronically Traded Funds. To invest in unlisted managed funds an application must be completed with the fund manager or their admin service. ETFs are managed funds that are purchased on the stock market that replicate the unlisted managed fund.

There are also two types managed funds that depend on the investing methodology of the fund manager. They are active fund managers and passive or index fund managers.

Index funds

A share index is a method of measuring the performance of the whole of a share market, such as the Australian All Ordinaries Index, or a sector of the market such as the top 200 companies by size.

Index funds tend to be very large as they hold all or nearly all of the companies that make up the index. As no research goes into working out what companies to buy and sell the management fee charged by index fund manager tends to be very low.

Index funds can be used to good advantage when a person wants to invest in a complete sector and use the index fund for rebalancing. Because share markets are often driven by sentiment, such as during the dotcom boom, an index fund allows the investor to be a part of a boom without investing directly in whatever the market loves at that point in time.

When a market has increased beyond what is generally regarded as a sustainable price to earnings ratios the index fund can be sold down with the cash proceeds being invested in other investment classes.

Active funds

Active fund managers hold a much smaller number of companies and are meant to thoroughly research companies before buying or selling them. This amount of extra work means the fee charged by active managers is higher than an index fund manager. This increased fee is meant to be offset by their funds earning more than what an index fund produces.

The unfortunate truth is that many fund managers say they are active, charge active manager fees, but make too many of their buy and sell decisions based on movements in an index. Active fund managers are meant to buy companies that are undervalued and sell companies because they are either over valued or it is time to take a profit.

Within the Australian share market greater diversification can be achieved by not just investing in the top 200 companies. There are managed funds that invest in middle sized companies and also in the small company sector. This small company sector does carry with it a higher risk but has produced at times higher returns.

Overseas share markets

If you think that investing in Australian shares is complicated because of the choices, the overseas share sector has an almost endless amount of choices. But investing into foreign markets is relatively easy these days, particularly through exchange-traded funds listed on the Australian market that hold shares in key offshore markets such as the US, Europe and Asia.

Separately Managed Accounts

There is now another alternative to managed funds called separately managed accounts. When an investment is made through a managed fund the manager decides what companies to buy and sell and shares purchased are owned by it. In an SMA the investor still gives an amount of money to a fund manager to invest on their behalf, but the shares are purchased in the name of the investor.

The benefits of SMAs are:

• the shares are owned by the investor,
• if the fund manager is changed the taxable capital gains impact is reduced,
• the investor knows what shares are being purchased and sold by the manager, and
• if decisions are not made on sound investment principles, but appear more to be made as a result of movements in an index, the investor can look for a more active manager.

Defensive growth assets

You won't find this asset class term in many books on investing, but it is the investment of choice for many Australians: direct property.

SMSFs can invest in property by:

• buying a property directly if they have sufficient funds,
• joint venturing in the purchase of a property with members or other superannuation funds,
• use the limited recourse borrowing rules for self managed super funds, or
• invest in unlisted property trusts that own either many properties or are a single property trust.

Unlisted property trusts have the characteristics of a defensive investment due to the regular income they produce but, unlike other defensive assets that are not expected to produce a capital gain; they can increase in value and produce capital gains like growth assets. Unfortunately like other growth assets they can also produce losses.

Another characteristic of unlisted property trusts, that makes them very much a growth asset, is that they should be held for at least five years and they are illiquid and must be held to maturity. In some cases the funds have set dates for redemption up to seven years from the date of investment.

The long maturity period for unlisted property trusts is another reason to make sure that you get the balance right when putting together your SMSF's investment portfolio. Losses from a property investment tend to come when a person has got the balance of their investments wrong and they are forced to sell.

Alternative assets

Alternative assets are often included as part of an investment portfolio to provide some protection from sharp movements in traditional investment markets. Their performance should not be affected by the performance of other investment asset classes. They are often not traded on an organised exchange or are otherwise difficult to access for the average investor.

They include commodities, natural resources, private equity, venture capital, and Agribusiness investments. Unfortunately due to the nature of managed investment schemes that allowed small investors to invest in agribusiness most people have lost considerable sums in this alternative asset class. For this to become a true alternative investment in the future major reforms will need to take place both at a regulatory and investment level.

Alternative investments also include those that do not clearly fit into one of the previous asset classes. This includes hedge funds which employ different strategies, such as long/short and event driven strategies, which make profits from the share market whether it is going up or going down via.

Originally there were not many managers operating in the hedge fund and alternatives area which meant funds were producing above average returns. Unfortunately this superior investment performance led to many fund management companies jumping into the sector which became overcrowded. As a result investment returns for hedge funds were severely reduced.

This asset class can carry with it a higher level of risk than the other investments, but the reason to include them in a portfolio is to provide an investment return that is not dependant on the factors affecting other investment classes. Care does need to be taken when investing in this sector as some fund managers and promoters of alternative investments, such as hedge funds, make it almost impossible for the investor to work out what they are doing.