Asset Classes

An asset class refers to a category of investments sharing similar characteristics. Examples include cash and cash equivalents, fixed-income securities like bonds, tangible assets such as property and commodities, and equities, commonly known as stocks.
EXPLORE FUNDS
Different Asset Types
EXPLORE FUNDS
4 mins
19-December-2024

An asset class is a category of investments that share similar characteristics and are governed by the same rules and regulations. It must be noted that within an asset class, the individual investments perform in a comparable manner in the financial markets. For example, stocks (equities), bonds (fixed income), commodities (like gold and oil), and real estate are all different asset classes. Each of these groups has its own characteristics and behaves in distinct ways.

Investors must understand these asset classes to smartly diversify their portfolios. Also, such an understanding helps in managing risks, as different asset classes often respond differently to economic changes. Let’s understand the different types of mutual funds based on asset classes in detail and learn what are alternative asset classes. We will also study the various additional factors primarily used for classifying assets.

What is an asset class?

An asset class refers to a category of investments that share common characteristics and operate under the same laws and regulations. The instruments within an asset class typically demonstrate similar behaviour in the marketplace, making them a cohesive group for investment purposes. Common asset classes include:

  • Equities: Investments in ownership shares of companies.
  • Fixed-income securities: Debt instruments, such as bonds, that promise to pay a specific return over a set period.
  • Real estate: Investments in property, including land, buildings, and other physical assets.
  • Commodities: Tangible assets, such as gold, oil, and agricultural products, traded in specialized markets.
  • Cash and cash equivalents: Highly liquid assets that can be easily converted into cash, such as short-term government bonds.

An asset class represents a grouping of financial instruments that share similar characteristics and are subject to the same regulatory framework. Common asset classes include equities, fixed income securities, cash and cash equivalents, real estate, commodities, and currencies.

It is worth mentioning that each asset class has a unique risk-return profile. This means they offer different levels of risk and potential returns. Also, this diversity allows investors to spread their investments across various asset classes to balance and manage overall risk. For example, stocks may offer high returns but come with higher risk, while bonds might offer more stable returns with lower risk.

By allocating their investments among different asset classes using the strategy of asset allocation, investors can:

  • Better achieve their financial goals
  • Match their risk tolerance, and
  • Enhance the performance of their portfolios

Such diversification protects against significant losses if one asset class performs poorly, as other asset classes might perform better under the same market conditions.

Types of asset classes

Asset classes are groups of investments with similar traits and behaviours. It must be noted that they can be classified using several criteria. For example, consumption assets like oil or investment assets can be categorised based on purpose. Similarly, they can be categorised on the basis of location (domestic or international) and market type (emerging or developed).

For more clarity and to make better classifications, let’s check out the various types of asset classes:

Fixed income

Fixed-income investments, such as fixed deposits and public provident funds (PPF), are highly trusted and popular in India. These investments assure capital protection and offer guaranteed returns. They are considered safe, with minimal to no risk of losing your initial investment.

Fixed income schemes mostly offer steady returns of around 7%-8%. However, these returns may not keep up with inflation. This means they provide security but do not significantly grow your wealth over time. Also, depending on the investment period, these returns are subject to short-term or long-term capital gains tax.

Equity

Equity investments involve buying shares of a company that gives you partial ownership. This asset class has become more popular recently. The main advantage is the potential for high returns as businesses grow and increase in value. However, there is also a higher level of risk due to market fluctuations that can affect share prices.

Among equity options, the Equity Linked Savings Scheme (ELSS) stands out for its tax benefits under Section 80C and a relatively short lock-in period of three years. Also, it is worth mentioning that historically, equities have provided returns of 16%-18%, often outpacing inflation. For successful equity investment, especially in the long term, you must choose a reputable Asset Management Company (AMC) with a strong track record.

Real estate

Some common examples of real estate investments include plots, apartments, commercial buildings, industrial areas, and villas. In recent years, interest in real estate has grown substantially, especially due to the launch of Pradhan Mantri Awas Yojana (PMAY), which aims to provide housing for all. This scheme extends beyond urban areas to semi-urban and rural regions.

However, the real estate market can be unpredictable, especially due to factors like:

  • City planning
  • Socio-political issues, and
  • Project development

Moreover, unlike other asset classes, real estate is not always well-structured or closely monitored. This makes it riskier and more variable in terms of returns.

Commodities

Commodities are tradable goods like gold, silver, bronze, food crops, and petroleum. Their market prices fluctuate based on demand. Also, each type of commodity behaves differently in the market. For example, the price of gold might rise when economic conditions are uncertain, while food crop prices can be influenced by weather conditions.

Commodities are generally not intended for long-term investments, except for some like gold and silver, which can retain value over time. The basic strategy for commodities is to buy when prices are low and sell when they rise. This approach allows investors to potentially profit from the price changes in these physical goods.

Cash and cash equivalents

Cash and cash equivalents, also called money market instruments, include currency, savings accounts, and other liquid investments. These provide the highest level of transactional freedom, as they can be easily accessed and used without restrictions. Many people prefer keeping money in savings accounts or in cash because they lack confidence in other investment schemes or want immediate access to their funds.

However, cash and equivalents usually offer low returns. These returns do not exceed 4% and mostly are unable to keep up with inflation. Additionally, some people hoard cash to avoid taxes, as it is difficult to trace and monitor.

Derivatives

For those unaware, a derivative is a type of financial contract. Its value is derived from the performance of an underlying asset, such as stocks, bonds, currencies, commodities, market indices, or interest rates. On its own, a derivative has no inherent value. Its price depends on changes in the value of the underlying asset.

The derivatives agreements are mostly held between two or more parties and specify certain obligations based on the contract terms. For example, a derivative might allow one party to buy or sell an asset at a future date for a predetermined price. These instruments are often used for hedging risks or speculative purposes.

Alternative investments

Alternative investments are a category of assets that don’t fit into traditional categories like stocks, bonds, or cash. These investments are often more complex and less regulated. They are mostly pursued by institutional investors or wealthy individuals.

Such investments offer high returns, but they come with higher risks. Also, they are often not easily converted into cash, which makes them illiquid. Some common examples of alternative investments include

  • Hedge funds, which pool capital to invest in various assets
  • Bitcoins and other cryptocurrencies
  • Valuable artworks
  • Structured products, which are customised financial instruments

Alternative investments can certainly yield significant profits, but their complexity and risk make them unsuitable for all investors.

Types of mutual funds based on asset class

Mutual funds can be classified based on the asset class they invest in. Here are some of the most common types of mutual funds based on asset class:

  1. Equity funds: These funds invest primarily in stocks . They invest the money pooled in from various investors from diverse backgrounds into shares/ stocks of different companies. The gains and losses associated with these funds depend solely on how the invested shares perform (price-hikes or price-drops) in the stock market. Equity funds aims to generate significant returns over a period but also carry higher risks.Explore more about, What are equity funds.
  2. Debt funds: These funds invest primarily in fixed-income securities such as bonds, securities, and treasury bills. They invest in various fixed income instruments such as fixed maturity plans, gilt funds, liquid funds, short-term plans, long-term bonds, and monthly income plans, among others. Since the investments come with a fixed interest rate and maturity date, debt funds can be a great option for passive investors looking for regular income (interest and capital appreciation) with medium risks.Read more about, What is a debt fund.
  3. Money market funds: These funds are a type of debt mutual funds, in these the money markets or capital markets by issuing money market securities like bonds, T-bills, dated securities, and certificates of deposits. The fund manager invests your money and disburses regular dividends in return. Opting for a short-term plan (not more than 13 months) can lower the risk of investment considerably on such funds.Read more about, What are money market mutual funds.
  4. Hybrid funds: As the name suggests, hybrid funds (balanced funds) are an optimum mix of bonds and stocks, thereby bridging the gap between equity funds and debt funds.

Additional factors in classifying assets

Apart from traditional asset classes like equities and fixed income securities, there are additional factors that can be used to classify assets:

  1. Market capitalisation: Market capitalization refers to the total value of all outstanding shares of a company’s stock. Companies with large market capitalizations are known as large-cap companies while those with small market capitalizations are known as small-cap companies.
  2. Geography: Companies can be classified based on their location or where they do business such as emerging markets or developed markets.
  3. Sector: Sector refers to the overall industry that a company operates in, such as technology or healthcare.

By understanding the different types of mutual funds based on asset class and their associated properties, investors can make informed decisions about their investments.

Investment strategies as per different asset classes

Investment approaches are influenced by factors like growth, value, income, etc. Here are several strategies used for asset allocation:

  1. Strategic asset allocation: Investors or fund managers distribute investments evenly across asset classes based on expected returns and considering investment duration and risk tolerance. Diversification is key to manage risks and enhance returns.
  2. Dynamic asset allocation: This strategy adjusts asset combinations as markets fluctuate or economic conditions change. Assets declining in value are sold, while those rising are bought to maintain portfolio returns.
  3. Integrated asset allocation: Considers an individual's economic outlook and risk tolerance to establish asset mixes, tailoring the strategy to the investor's risk appetite.
  4. Insured asset allocation: Establishes a minimum benchmark value for portfolio returns. If returns exceed this base, active management strategies are employed. If returns fall below, investments are shifted to risk-free assets to stabilize the portfolio. Suited for risk-averse investors desiring active management and a safety net for their investments.

Asset classes and diversification

Diversification is a key investment strategy that reduces risk by spreading investments across various asset classes, such as stocks, bonds, real estate, and commodities. The primary goal of diversification is to avoid putting all your money into one type of investment. If that particular asset class performs poorly, it can significantly impact the overall portfolio returns.

It must be noted that different asset classes respond differently to economic conditions. For example, during economic downturns or recessions, stocks often struggle and lose value. On the other hand, bonds or real estate perform better and provide positive returns. This way, by investing in a mix of asset classes, you can protect yourself from severe losses in any single area, as the poor performance of one asset class gets offset by better performance in another.

Additionally, each asset class has its own risk and return characteristics. For example, stocks offer high returns but come with higher risk, while bonds provide more stability but lower returns. Diversification, as a technique, also helps balance these risk and return characteristics of your overall portfolio. By combining various asset classes, you can create a portfolio that matches your personal risk tolerance and investment goals.

Asset allocation and risk tolerance

Asset allocation is the strategy of dividing your investment portfolio among different asset classes, such as stocks, bonds, real estate, and commodities. This approach balances the potential for earning returns with the level of risk you are comfortable taking. The underlying principle often used in this approach is that different asset classes behave differently under various market conditions. For example:

  • Stocks offer high returns but are also more volatile.
  • Bonds generally provide more stability and regular income but generate lower returns.
  • Real estate can offer steady rental income and potential for property value appreciation.
  • Commodities like gold and oil can serve as a hedge against inflation but can also be unpredictable.

By spreading investments across these asset classes, you can reduce the risk of losing money in any one area and increase your chances of achieving long-term financial goals. Furthermore, investors must understand the concept of risk tolerance, which is the degree of variability in investment returns that an individual is willing to withstand. It depends on several factors, such as:

  • What you aim to achieve with your investments, such as saving for retirement, buying a home, or funding your child’s education.
  • The amount of time you plan to hold your investments before needing to access the funds. Always remember that longer horizons usually allow for higher risk tolerance because there's more time to recover from market downturns.
  • Personal comfort with seeing the value of your investments go up and down. Some people are more comfortable with the inherent uncertainty of higher-risk investments, while others prefer stability.

For example, someone with a high-risk tolerance might invest more in stocks, which can be volatile but offer higher potential returns. On the other hand, someone with a low-risk tolerance might favour bonds, which are more stable but provide lower returns.

As a thumb rule, the mix of asset classes in your portfolio should reflect your risk tolerance. This alignment ensures that your investment strategy matches your financial goals and comfort level with risk. To get more clarity, let’s see how both of them are related:

  • High-risk tolerance: If you can handle volatility and have a long-term investment horizon, you might allocate a larger portion of your portfolio to stocks. This can lead to higher returns over time, though it comes with higher risk.
  • Low-risk tolerance: If you prefer stability and have a shorter investment horizon, you might allocate more to bonds and cash equivalents. These investments are less volatile but generally offer lower returns.

Moreover, it is important to understand that major life events, such as changes in your financial situation or approaching the end of your investment horizon, can substantially impact your risk tolerance. Hence, it is important to regularly review and adjust your asset allocation. These regular reviews ensure that your portfolio aligns with your evolving needs and goals.

Alternative asset classes

Alternative asset classes refer to investment options beyond traditional categories such as equities, bonds, and cash. These include real estate, private equity, hedge funds, commodities, infrastructure, and art. Unlike conventional assets, alternative investments often exhibit lower liquidity, higher risk, and less transparency, but they can offer enhanced returns and diversification.

Investors often turn to alternative asset classes to hedge against market volatility, as these assets typically have a low correlation with traditional markets. For instance, commodities like gold tend to perform well during economic downturns, while private equity offers exposure to high-growth companies not listed on public exchanges.

These investments generally require a longer holding period and significant capital, making them more suitable for institutional investors or high-net-worth individuals. Alternative assets are also impacted by external factors, such as political changes or global demand trends, requiring careful research and expertise. When used strategically, alternative investments can play a pivotal role in optimising portfolio performance.

Asset class and investing strategy

An asset class is a group of financial instruments sharing similar characteristics and governed by the same regulations. Common asset classes include equities, fixed income, and cash equivalents, while alternative asset classes encompass real estate, commodities, and hedge funds. Each class exhibits unique risk and return profiles, making it essential to align investment choices with individual financial goals and risk tolerance.

The selection of an asset class often determines the foundation of an investing strategy. For instance, equities are preferred for long-term growth, while bonds provide stability and consistent income. Cash equivalents, such as Treasury bills, offer safety and liquidity, ideal for conservative investors. Diversifying across multiple asset classes is a key strategy to mitigate risk and enhance returns.

Investors may also adjust allocations within asset classes based on market trends, economic forecasts, or personal circumstances. For example, during periods of inflation, commodities might become more attractive, while bonds could underperform. A well-thought-out strategy that leverages the strengths of different asset classes ensures a balanced portfolio capable of navigating varying market conditions.

Additional factors in classifying assets

Beyond traditional classifications like asset type or market capitalisation, several additional factors play a role in classifying assets, allowing for a more nuanced approach to portfolio construction and risk management.

Liquidity is a critical factor, distinguishing between assets that can be easily bought or sold (e.g., stocks, bonds) and those requiring longer holding periods, such as real estate or private equity. Liquidity impacts an investor's ability to respond swiftly to market changes.

Geographical region is another key classification. Assets can be divided based on domestic or international exposure, helping investors diversify across global markets. For instance, investing in emerging markets may offer higher growth potential but with increased risk compared to developed markets.

Sector and industry focus categorises assets within specific economic segments, such as technology, healthcare, or energy. This classification allows investors to target industries expected to perform well in certain economic cycles.

Risk profile is also essential, separating high-risk, high-reward investments like equities from low-risk, stable options like government bonds.

Lastly, investment horizon can classify assets based on short-term, medium-term, or long-term goals, aligning with an investor’s financial objectives.

These additional layers of classification help investors design tailored strategies, maximise diversification, and achieve optimal returns while managing risk effectively.

Key takeaways

  • An asset class refers to a category of investments sharing similar characteristics and governed by the same rules and regulations.
  • Common asset classes include equities, fixed income, cash equivalents, real estate, commodities, and currencies.
  • Different asset classes often respond differently to market changes, sometimes moving in opposite directions.
  • Financial advisors use asset classes to diversify investments across categories, reducing risk and enhancing stability.
  • Spreading investments across various asset classes helps balance risk and optimise returns, creating a more resilient investment portfolio.

Conclusion

Mutual funds offer investors a diverse array of asset classes, each catering to different investment objectives, risk appetites, and time horizons. Whether seeking growth, income, or a balanced approach, there is a mutual fund strategy suited to every investor's needs. By understanding the various asset classes and investment strategies available, investors can make informed decisions to build portfolios aligned with their financial goals. With the potential for growth, the benefits of diversification, and the expertise of fund managers, mutual funds remain a cornerstone of successful investment journeys. Embracing the flexibility and opportunity they offer, investors can navigate the complexities of the financial markets with confidence, empowered to pursue their long-term wealth accumulation goals.

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Frequently asked questions

What are asset classes in SIP?

Systematic Investment Plans (SIPs) is a way of investing in mutual funds which offer a range of asset classes for investors. These asset classes are essentially different types of investments that exhibit similar characteristics.

The primary asset classes in mutual funds include stocks, bonds, commodities, etc. These classes provide investors with choices to diversify their portfolios based on risk tolerance and financial goals.

What are the most popular asset classes in India?

In India, the most popular asset classes include fixed income, equity, real estate, and alternative investments. Fixed income assets like fixed deposits and public provident funds (PPF) are trusted by many.

Equity or stock are shares of ownership issued by companies. Real estate focuses on properties like apartments, plots, and commercial buildings. Alternative investments can range from commodities to derivatives.

Each of these asset classes has unique characteristics and risk-reward profiles. Diversifying your investments across different asset types can help manage risks and maximize returns.

Why are asset classes useful?

Asset classes are crucial for diversifying investment portfolios. They encompass different asset types like equities, fixed income, cash equivalents, real estate, and commodities. Each of these types of asset classes behaves differently in the market. By investing across multiple asset classes, investors can balance their returns and losses. For instance, mutual fund classes allow investors to invest in a mix of asset classes. This diversity minimizes risk as your funds come from multiple sources. Hence, understanding different asset types and the benefits of diversification across various types of asset classes can help achieve financial goals.

How to purchase investments from different asset classes?

To diversify across asset classes, investors can use brokerage platforms or financial instruments like mutual funds and exchange-traded funds (ETFs). These vehicles provide exposure to various asset classes such as stocks, bonds, real estate, and commodities, allowing investors to easily access diverse investment opportunities within a single platform.

What are the 7 asset classes?

Asset classes are groups of investments with similar characteristics. Below are the seven most common asset classes:

  • Fixed income: These are safe investments like fixed deposits and PPF in India. They offer steady returns (7%-8%) but provide limited growth as they don’t usually beat inflation.
  • Equity: It represents stocks that provide partial company ownership. They offer higher long-term returns (16%-18%) but come with higher risk.
  • Real estate: These are investments in properties and are influenced by factors like city planning and government schemes. They offer growth but with unpredictability.
  • Commodities: This category includes tradable goods like gold and oil. They are often preferred because they offer potential high returns during price fluctuations.
  • Cash and cash equivalents: These represent liquid investments like savings accounts and liquid mutual funds. They offer low returns (around 4%) but provide high liquidity.
  • Derivatives: These are financial contracts that derive value from other underlying assets (stocks, bonds, etc.). Commonly, derivatives are used for hedging or speculation purposes. Their value is tied to underlying asset movements.
  • Alternative investments: This asset class represents non-traditional assets like hedge funds, bitcoins, and artworks. It is mostly pursued by high-net-worth individuals. Such investments generate high returns but come with high risk and complexity.
What asset class is gold?

Gold falls into the "commodity" asset class. Commodities are physical goods that are traded, and gold is a prime example. Its value fluctuates based on market supply and demand factors. Investors often buy gold as a hedge against inflation and economic uncertainty.

What asset class is silver?

Silver, platinum, and palladium are commodities in the precious metals category. Each metal offers unique investment opportunities and risks as it has varying industrial uses and market demand. Silver is widely used in electronics, while platinum and palladium also have various industrial applications. This makes them valuable, but their price fluctuates based on industry trends.

What is a commodity asset class?

Commodities offer returns that do not move in sync with stocks and bonds. As a distinct asset class, including commodities in your investment portfolio can reduce overall risk and possibly increase returns. Furthermore, their unique price movements can provide a balance to your portfolio and make it more resilient to market fluctuations.

What asset class are derivatives?

Derivatives are an asset class that is classified into the categories of forex, futures, and other derivatives. They are financial assets that include instruments like futures contracts, forex (foreign exchange) agreements, and options. These instruments derive their value from an underlying asset, such as stocks, bonds, or commodities. Mostly, investors use derivatives to hedge risk or speculate on price movements.

What is the riskiest asset class?

Equities are considered the riskiest asset class due to their high volatility and susceptibility to market fluctuations. Factors like economic changes, company performance, and global events can significantly impact returns. However, they also offer the potential for high long-term growth, making them appealing for risk-tolerant investors.

Which is the safest asset class?

Cash and cash equivalents are regarded as the safest asset class. These include instruments like savings accounts, Treasury bills, and money market funds, which offer low risk and high liquidity. Although their returns are modest, they provide stability and preserve capital during uncertain market conditions.

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