Executive Summary
The following report provides a detailed and exhaustive description of asset classes according to their characteristics and related advantages and disadvantages. Consequently, the paper considers 5 most important asset classes, including both local and international shares, bonds, cash and listed trusts. Further, according to the given statistical data regarding the levels of revenue of these classes of assets, the author conducts corresponding calculations evaluating their average profitability and effectiveness in investment portfolio along with clarifying what exact type of portfolio should be conducted for an investor operating with these securities in order to achieve maximum level of revenue with relatively low level of risk. Further, the author discusses various theoretic and situational questions related to the topic. Corresponding conclusions are given in the final section of the project.
Describe each of the asset classes, setting out their characteristics and risks. 4
Calculate the AM (Arithmetic Mean) and GM (Geometric Mean) measures of the average annual yield on each of these asset classes during the period 1983-2003. Contrast the resulting measures of average yield for each asset class. 5
What would be the main problems you would encounter if you tried using the efficient frontier you have identified for portfolio selection purposes? 7
How does foreign exchange risk contribute to the risk of international investments? Is it worthwhile to hedge exchange rate risk? 8
During a world financial crisis, all the major financial markets will usually move in the similar direction (i.e. become highly correlated). Do you think this will limit the benefits of international diversification? 9
It is often said that Australian investors have an inefficient home bias in their asset portfolios. What does this mean? Why is it important? What are the principal causes of “home bias”? 9
Conclusions 10
References 11
Describe each of the asset classes, setting out their characteristics and risks.
A class of assets is a corresponding group of financial instruments that tend to have similar or sometimes equal attributes and characteristics; therefore, they also tend to be operated on a financial market in similar way. Specialists generally tend to distinguish the assets classes into the ones particularly dealing with financial assets, while the rest are closely related to the real assets. It appears more than common for the assets comprising the same assets class to represent the same subjects of similar laws, regulations and recommendations regarding their definitions and operations with them. Still, the last may not always be true due to various financial peculiarities; for example, futures on an asset are generally identified as being the part of the same class of assets as the underlying instrument; however, the same futures are subject to significantly different laws compared to the underlying instrument.
Particularly, a number of investment funds is comprised of 2 fundamental classes of assets, both securities: fixed-income in the form of bonds and the equities in the form of stocks. Nevertheless, it is worth reminding that some of them tend to hold foreign currencies and cash among their resources. The same funds can also hold various money market instruments, rarely turning to using different cash equivalents regardless of the fact that this neglects any potential possibility of default. In other words, along with aforementioned bonds and stocks, the asset classes also include commodities, real estate, foreign currency and, certainly, cash. Due to the fact that these classes have been logically distinguished, all of these represent different benefits and risks in operations on financial market; moreover, the efficiency of these asset classes is also highly dependent upon the market environment, as well (Tiaa-cref.org, 2016).
Having given the brief theoretic insight into main asset classes, it is worth defining the ones given initially in the table, showing the dynamics of these classes. It appears more than necessary to have a clear understanding of these classes’ nature before further discussing their peculiarities and analyze the operations and situations connected to them. In this regard, it is worth stating that stocks (usually called “equities”) represent the financial instruments showing the exact ownership shares in respective publicly held organizations. One of the main characteristics of them is its high volatility compared to the rest of assets; consequently, their returns may fluctuate to an extent that the resulted accumulations may appear significantly higher compared to the nominal cost of a stock. In addition, they also appear to function on global financial markets the longest.
Bonds or fixed income traditionally function according to a set interest rate during a particular period; thus, they illustrate significantly higher stability compared to the stocks, as the bonds’ value tends to change according to the inflation rates and the interest rates. In addition, this asset class includes “risk-free” or “guaranteed” assets. In other words, they are significantly more reliable compared to stocks, as they will not result in values lower than nominal ones; still, the aforementioned income accumulations related to stocks are not common for bonds either.
The definition of cash is simpler compared to the aforementioned assets, as it represents the physical form of money – the currency (both coins and banknotes). In terms of finance, it’s the form of current assets consisting of both currency and its equivalents for an immediate access. It is generally used to maintain the positive cash flow and/or to evade the financial markets’ downturns. The international shares comprise of the aforementioned stocks operating on international and global financial markets. In other words, the only difference between simple stocks and international shares in the level of financial market, where they tend to operate. Another interesting class of assets is going to be analyzed further, as it comprise of the Listed Property Trust Funds. The last offer the investors an opportunity to operate with securities related to property and property itself listed on the national securities exchange. Due to the fact that this paper is going to analyze the Australian financial market, these Trusts Funds are logically appear to be listed on the Australian Securities Exchange. The Fund transfers its respective investments in Real Estate Investment Trusts (REITs) and corresponding securities related to property.
Calculate the AM (Arithmetic Mean) and GM (Geometric Mean) measures of the average annual yield on each of these asset classes during the period 1983-2003. Contrast the resulting measures of average yield for each asset class.
The following table offers the corresponding calculations for Arithmetic Mean (AM) and Geometric Mean (GM) according to each type of the asset classes within the period 1983-2003. Accordingly, the highest average yield among the asset classes show the Australian Shares within the aforementioned period. The second place is divided between the returns of International Shares and Listed Property Trusts, while the returns from cash appear to be the lowest. In addition, the Australian Bonds have proven to be more stable in comparison with the rest, still offering limited amounts of return.
However, it is still worth stating that evaluating the average annual yields of the asset classes is not sufficient to have a clear and exact picture of what particular portfolio of these assets would be the most beneficial and profitable, also taking into consideration the least percentage of risk associated with operating this asset class on a particular financial market. In addition, the proportion of these assets remains unclear. According to the calculations, the portfolio revenue comprising of equal proportions of each assets class would be 106.24% for 2003. Still, it is worth accepting that it is not the most efficient portfolio that could be.
Therefore, there is a corresponding need of calculating the efficiency frontier according to traditional and standard methods. Due to the large massifs and arrays of financial data, there is no exact point in illustrating the detailed calculations of this index. In fact, taking into consideration that there are 5 asset classes available for constituting the investment portfolio, the current project has analyzed 52 possible scenarios of having a particular investment portfolio. Each of these is represented as fully comprising the portfolio (100%), making 75% of it, 50% and 25%. Correspondingly, the percentages of the rest four asset classes have been randomized and calculated accordingly.
Therefore, the calculated efficiency frontier logically shows that the increased portfolio revenues are closely associated with corresponding risk and vice versa. The least risky option for portfolio would be having all the portfolio comprised of cash, still, it would also be the least profitable option. On the contrary, the highest risk and correspondingly highest revenues shows the portfolio variant that has Australian Shares and International Shares divided equally. Having taken into consideration the high risks of the shares themselves, such trend appears to be more than logical. Nevertheless, the most effective option for portfolio would be having 75% of operations with listed property trusts and 25% with the international shares, as according to calculations this particular option has proved itself particularly profitable with relatively moderate level of risk.
The detailed graph of efficiency frontier is available in Table 2.
What would be the main problems you would encounter if you tried using the efficient frontier you have identified for portfolio selection purposes?
According to the statements of CAPM, the portfolio can and should be effectively optimized, as the optimal portfolio illustrates the result of lowest possible risk level according to the corresponding amounts of return. Furthermore, once each additional asset is inserted into the portfolio, the combination of these optimal portfolios create the efficient frontier (Berkman, 2012).
Addressing this question to the corresponding work conducted by Markowitz, the majority of investors and financial managers appear to be familiar with the concept of mean/variance efficiency. The concept is based upon the corresponding assumption that the investors are most likely to achieve a certain level of revenues on their investments with as much predictability and certainty as the desired level of revenue affords. In other words, for any investor it is crucial to receive the highest possible return for a particular return variation level. Correspondingly, the portfolios fulfilling this requirement the best are identified as the most effective portfolios or variance efficient (Markowitz, 1987).
However, the critics tend to state that constructing a corresponding efficient frontier may become not that beneficial for the investors and even misleading and hazardous, as a result. In particular, constructing such graph simply makes them feel better about their situation, which could be not that good. What do the investors see, as the result of constructing the efficient frontier is that the normal frontier lies close to better revenues with least risks on a good market situation and vice versa. However, the empirical studies show that the same efficient frontier is being present on bad market (Davis, 2008). This is the result of optimization problem, as it shows the best return/variability trade-off according to the covariance and expected returns of corresponding asset classes (Clark, 2004).
Therefore, in order to fully understand and utilize the efficient frontier adequately, it is necessary to calculate the detailed portfolio configurations along with corresponding levels of variance and covariance.
How does foreign exchange risk contribute to the risk of international investments? Is it worthwhile to hedge exchange rate risk?
All the investors busy investing into overseas assets functioning on international markets during the first years of the 21st century achieved significant benefits from the weakening of USD being in conditions of a long-term decline. Moreover, hedging the foreign exchange risk has been not preferable during those years due to the fact that the investors have been holding corresponding assets in a currency different from USD (Hakala and Wystup, 2002).
Still, the same status of weakening currency can also accumulate negative returns in the same portfolio. For example, holding assets in a gradually depreciating currency may also result in losing revenues in local currency. In this case, it is more than necessary for an investor to consider using the currency ETFs in order to hedge his risks associated with the currency exchange rates’ fluctuations (Shapiro, 1978).
Nevertheless, the foreign exchange risk appears to be one of the most significant to consider for every investor operating on an international financial market and is vital for everyone making corresponding operations of financial and/or commercial nature in foreign currency.
During a world financial crisis, all the major financial markets will usually move in the similar direction (i.e. become highly correlated). Do you think this will limit the benefits of international diversification?
The empirical studies have proved that highly correlated markets appear to create certain combination of financial and statistical indexes almost similar between each other; moreover, they show joint dynamics of most of them. In other words, such trend is called a market mode (Sandoval, 2011).
Therefore, during the time of crises, the benefits of international diversification appear to be significantly limited due to the fact the financial markets of both local and international level appear to be reacting upon the conditions of crisis in similar and even the same way. Thus, the international diversification would appear less effective and rational, as even investing into another currency makes less sense if it shows the same dynamics as the local one.
It is often said that Australian investors have an inefficient home bias in their asset portfolios. What does this mean? Why is it important? What are the principal causes of “home bias”?
The corresponding trend of investors to invest in significantly large amounts of domestic or local equities or assets is generally identified as “home bias”; furthermore, the trend of home bias is actual not only for the Australian investors, but for the rest of their foreign colleagues on financial markets, as well. This remains actual even nowadays, when the theoretical and practical works have effectively proved that diversifying the investment portfolio with the respective foreign investments is more than adequate measure in decreasing investment risks. Still, the bias remains actual due to the fact that for investors all over the world operating on foreign exchange markets is closely associated with the difficulties related to legal limitations and additional transaction costs, as well.
Even despite the fact that the home bias is identified as important and disputable issue in international financial relations, the scholars remain arguing regarding the reasons of why do the investors tend to prefer domestic securities rather than the foreign ones. In this perspective, home bias is divided into two big groups according to the corresponding explanations of the scholars: the first group is associated with the corresponding frictions related to the distance, while the second is associated with various governmental and national frictions. The first appear to be evident and more than logical, as the effect of distance may result in creating more trust in local financial markets. It has been practically proved that the geographic proximity influences the choice of investor regarding comprising his overall investment portfolio. In addition, “on an international scale, investment proximity may account for a large portion of the observed abstinence in holdings of foreign securities” (Coval and Moskowitz, 1999).
In addition, the researchers have also identified particular characteristics of the firm that tend to explain the preferences of local equities and their substantial fraction. In particular, different local holdings tend to be present in little firms that are generally not occupied in production of physical items; thus, they appear to be showing significantly higher levels of financial leverage. Consequently, “these results suggest that information asymmetries may be driving the observed preference for geographically proximate firms. Moreover, they may indicate an important link between local equity preference and the cross-sectional asset pricing implications associated with size and firm distress. Finally, these results are common across a variety of manager types and fund classes” (Coval and Moskowitz, 1999).
Eventually, there is still additional research needed focusing on particular issues associated with home bias; for example, in order to completely comprehend the association between the investors’ local equity preference and related anomalies of cross-sectional asset pricing, there is a great necessity to analyze the investors’ geographical location more exhaustively.
Conclusions
Summarizing everything that has been stated previously, it is worth concluding that the current project has defined and theoretically analyzed the most popular and most important classes of assets, giving them corresponding characteristic. In addition, the paper has shown the practical example of how can the exact combination of assets be defined and used in order to achieve the highest level of revenues with a relatively low or moderate levels of risk. However, it is still worth accepting that the used approach of efficient frontier may not usually be as effective as it could be due to the reasons mentioned above, as well. Eventually, the paper has discussed the preferences of investors to spend their attention, time and funds in investing into only the local equities and assets. Along with this, the importance and the reasons of this “home bias” have been discussed.
References
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Bornholt, G. (2012). The Failure of the Capital Asset Pricing Model (CAPM): An Update and Discussion. Abacus, 49, pp.36-43.
Clark, T. (2004). Stop playing with your optimizer. Dimensional Fund Advisors.
Coval, J. and Moskowitz, T. (1999). Home Bias at Home: Local Equity Preference in Domestic Portfolios. The Journal of Finance, 54(6), pp.2045-2073.
Davis, J. (2008). Efficient Frontiers Constructed with Historical Data Can Be Misleading. Dimensional Fund Advisors. [online] Available at: https://us.dimensional.com/media/50845/efficient_frontiers_misleading.pdf [Accessed 14 Feb. 2016].
Hakala, J. and Wystup, U. (2002). Foreign exchange risk. London: Risk Books.
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Markowitz, H. (1987). Mean-variance analysis in portfolio choice and capital markets. Oxford, OX, UK: B. Blackwell.
Sandoval, L. (2011). Correlation of financial markets in times of crisis. [online] Available at: http://arxiv.org/pdf/1102.1339.pdf.
Shapiro, A. (1978). Foreign exchange risk management. New York: AMACOM.
Tiaa-cref.org, (2016). TIAA-CREF - Asset Classes. [online] Available at: https://www.tiaa-cref.org/public/advice-guidance/education/saving-for-retirement/basics/asset_classes?p=1331944007105 [Accessed 13 Feb. 2016].
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