Categorizing Asset Classes

[eytonxav]

I was wondering how some asset classes should be classifed when trying to determine overall mix of equity to fixed income. Specifically I am wondering about TIPS mutual fund/index fund, reits, and preferred stocks. Are these assets treated as fixed income or equity when trying to calculate overall mix?

Thx,

Doug

 

[RYD]

DFW_MS

TIPS are bonds so they are treated in that class. Index funds are classified as to what they are indexing if it is stock (SP500) then it goes to equity it it is bonds (total bond market) then to bonds. I treat REITs as equity as the underlying asset is not a debt insturment which is what in effect a bond is. Perferred stock is an equity.

Good luck and I suggest you check out various sites to get a good solid understanding of these classes and the interplay betwen them. coffeehouse investor is one site another is morningstar or efficent froentier. Lots of very good and easy tpo reas books on this as well.

Sorry about the spelling never my strong suit

 

[wabmester]

I mostly agree with RYD, but preferred stocks probably behave more like bonds. If you have convertibles, treat them as stock once they convert, but I'd treat them as debt while they pay a dividend.

REITs can be either debt or equity. You have to make a case-by-case classification if you own individual REITs, otherwise just punt and treat a REIT fund as equity.

From a diversification standpoint, real estate behaves differently than other asset classes, so I separate it out. I target a specific mix of cash, bonds, domestic stocks, international stocks, and real assets.

Some people like to "slice and dice" their stocks into a specific allocation. I prefer to start with a core of TSM and then change the weighting a bit by adding a dash of small cap value, and a couple of sectors I want more exposure to.

I take a similar approach to real assets, starting with core real estate holdings and adding a dash of metals and commodities.

 

[charlie]

Hi Doug,

Some people would argue that TIPS should be
regarded as a separate asset class even though
they are bonds. This is because of their sensitivity
to changes in real interest rates and protection
against inflation.

Regards.

Charlie

 

[eytonxav]

I actually have been leaning toward considering my tips, individual reits, and preferred stocks as being non-equity type assets. I usually term all my non-equity investments as fixed income and I am trying to get my mix such that equity portion represents about 40-45% of overall portfolio; so where I place the aforementioned can have a dramatic effect on the equity %.

Thx,

Doug

 

[ats5g]

Doug,

Here's how I think about it. Anytime you hold a stock of something, you're a part owner of that corporation. Anytime you hold a bonds, you're a creditor (or debter - I can't remember which term goes with whom) - anyway you lend your money to the corporation and have claim on their assets. If the company goes under, the bond holders are in front of the stock holders in line to get their money back.

I believe that preferred stock holders would be b/w the bond holders and the stock holders in line.

Therefore, I treat REITs, no matter how "safe" and "well run" as equity. They have equity like risks. Just b/c they can be considered a seperate asset class, like commodities, (according to people like Fama & French) does not mean that they are any less risky than equities.

I also like to think in terms of risky and not-so-risky assets. Equities, REITs, Commodities, High Yield bonds are risky assets, b/c they all involve a rather high amount of market risk. Do they move together? Not really, however that doesn't make them "less risky". Short Term bonds, Int term bonds, are the no-so-risky assets. I'm unsure about where to place preferred stocks, real estate (houses), and even TIPS. Most likely somewhere in the middle.

- Alec

 

[cute fuzzy bunny]

I treat the following as separate asset classes, listed here in descending risk/volatility potential (by my classifications)

Emerging Market stocks
Foreign small cap stocks
Foreign large cap stocks
Small cap US stocks
Large cap US stocks
Real estate including REITS
Oil, Gas and Utility stocks
Corporate Bonds
Foreign Bonds
Muni Bonds
Treasuries and other government bonds, including tips
Cash instruments like MM and CD's

I assign a different risk/return level to each, note the long term and short term correlations (if any) between any two asset classes, and divide my resources between them as a function of risk vs return, volatility and reduced correlation as a function of volatility.

To answer the original question, most financial software considers REIT's to be small cap stocks, which I find silly as they return, behave and correlate nothing like typical small caps, hence my treatment as a separate asset class. I would treat TIPS differently from other treasuries but would clearly treat them as a fixed income asset.

I actually consider preferred stocks to be a type of high dividend equity.

The bottom line is I dont think its effective to cut things into equities and fixed income, in large part because in some cases these asset classes are correlated with each other. Breaking investments into correlation buckets and investing accordingly makes more sense to me.

 

[unclemick]

Correlation buckets? Where do you get your buckets? Where you find your correlation among asset class numbers. I look at Yahoo Finance risk metrics - R squared, Beta, Alpha, and SD which isn't the same thing. I know people who use MPT need this data but where do they get/use it?

 

[cute fuzzy bunny]

Eh I read stuff and did some evaluations of when things yinged and when they yanged vs other stuff. I added a column to my asset allocation spreadsheet that has an arbitrary numbering system of 1-5. I assign a number to each asset correlation 'bucket' and then in aggregate multiply out the dollar amount I have in each class, the risk factor, the typical historic return, risk as a function of return (bang for the risk buck), and dollars per 'bucket'. If I keep my assets balanced between uncorrelated 'classes', varietal volatility affects me less. I started with all my money in the least risk for return bucket and started shifting money into the riskier, more volatile buckets until the average (historical) return exceeded my withdrawal + inflation needs. Then I turned the knob another 15-20% towards risk/return. Then I bought the correlating funds in those amounts with vanguard.

Some of my rough notes.

Emerging Markets, US Stocks and foreign stocks are often all on different tracks. Sometimes one tracks the other but over moderate terms one or more usually is doing better than others.
Small US and Large US stocks are often on the same correlation track.
US and Foreign bonds are on different correlation tracks.
Real estate and oil/gas/utility stocks frequently run on similar correlation tracks.
Bonds and stocks in the same country are often tracking similar.

Specific effects:
High inflation hurts both stocks and bonds in the country in which it occurs.
Declining inflation helps stocks and bonds in the country in which it occurs.
A countries currency rising helps both stocks and bonds in that country.
Declining currency hurts stocks and bonds in that country.
Money markets, tbills and cash perform similar to bonds in terms of correlation on returns.

My buckets are:
1 - US stocks and corporate bonds
2 - Emerging market stocks (emerging market bonds have their own category - flushable money)
3 - Foreign stocks and bonds
4 - REIT and oil/gas/utility stocks
5 - Treasuries, cash instruments

Its not hard and fast; some days it all moves in the same direction. Sometimes for years they move together or diverge against the buckets outlined above. For the most part though spreading the wealth between the buckets should substantially reduce your volatility.

I keep the small caps, emerging markets, and reits in my IRA, and I started a Roth IRA with 2003/2004 contributions allocated to TIPS. There Ted, I bought some of the damn things even though I think the returns will be pitiful until screaming inflation comes along. The US large caps, corporate and treasuries, and europe and pacific indexes are in my taxable account. That way the most volatile stuff with the highest long term growth potential is my long term "bigger bucket" and the lower volatility high income producers are in the taxable "bigger bucket".

What I find interesting is the frequent (and in fact also in my portfolio) lack of interest in mid cap stocks. Did everyone know that most of the vanguard board and management have the mid cap value Windsor fund as their largest holding?

 

[unclemick]

TH Unmasked!

What TH - you mean you don't have a pipeline to hapless TA's cranking out 'rolling correllation data' as grist for their profs. MPT classes?

Also the flyer on the dryer sheet IPO hasn't come in the mail yet.

BTY- I think the vanguard people you mentioned are 'technically old pharts' and probably started when they were young in the taxable realm - before all this 'modern stuff'. And I suspect even Bogle's portfolio would prove interesting - given that his index only showed up in the 70's.

 

[cute fuzzy bunny]

Ah, I wish I had access to said hapless TA's.

I wish I could find the article I read, perhaps I'll look some more later. Curiously the vanguard board and long time execs hold very little in the index area, but a common thread was their holdings of that mid cap value windsor fund.

When probed on it, a spokesman said the holdings were 'old' and there would be significant tax implications if any allocations were changed, so they arent changing them.

With regards to the new dryer sheet fund, I need your check first along with a SASE to send you back the prospectus.

 

[unclemick]

TH
RE: fore mentioned hapless TA's (www.wsharpe.com) of Stanford bus., Financial Engines and other fame has data on the web that might be worth poking thru - unfortunately my webtv is outdated and underpowered. ? Is this the grist for 'Financial Engines' working of asset class correlation?

 

[cute fuzzy bunny]

I'll have to have a look-see. By the way, my girlfriends name is (cough) Sharpe...