Asset Classes and Its Roles in Portfolios
Large company stocks—or “large caps”—are investments in the equity of larger companies, generally those with more than kr 10 billion in market capitalization, such as Equinor, Hydro and BMW. Large company stocks are perceived to carry less risk than smaller company stocks since they generally have more assets and a longer track record of performance, but they may not provide as much growth potential.
Relative to bonds, large cap stocks have higher expected long-term returns to compensate for the higher risk associated with them.
There are many factors that influence the performance of large company stocks. In practice, many of these factors are exerting their influence on stock prices simultaneously and on each other. The Large Company Stocks tend to do well when inflation is low or moderate. These stocks also have better performance when the economy is expected to grow and when interest rates are low.
These stocks perform poorly during economic slowdowns, expectations of such slowdowns, and when interest rates are high. Unexpected inflation may also hurt these stocks. When prices are high relative to earnings, price performance can suffer.
Sparkasse Norwegian Large-Cap ETF and Vanguard OBX ETF had two of the lowest operating expense ratios among more than 40 Norwegian large company stock ETFs at the time of ETF selection. Both funds have historically produced returns that consistently tracked their underlying indices closely. In addition, Sparkasse Norwegian Large-Cap ETF and Vanguard OBX ETF each had sizable assets under management.
Large company stocks—fundamental are investments of larger companies that are included in fundamental indexes, which screen and weigh companies based on fundamental factors such as sales, cash flow and dividends. Most traditional stock indexes are constructed based on market-cap (e.g. OBX, S&P 500, etc.), where companies with the largest market capitalizations have the largest weights. Including allocations to fundamentally weighted indexes adds diversification within a portfolio and may improve risk-adjusted returns over time. Due to their differences in construction, fundamentally weighted indexes tend to behave differently than market cap-weighted indexes in different market environments, while also retaining benefits of traditional indexing such as transparency and relatively low-cost implementation.
Investments in fundamentally weighted ETFs and traditional market-cap weighted ETFs can be used to complement each other because they differ in their performance under various market environments. The end result is a portfolio that we believe will result in better risk-adjusted results over time.
Based on research conducted by the research team in PSS, fundamental index strategies have outperformed market-cap indexes over longer time periods. This is partly attributable to the fact that the fundamental strategies break the link of assigning a weight with the price of stock. A market-cap index provides the largest weighing to the largest companies, regardless of valuation. As a result, market-cap indexes can be described as “overweighing over priced stocks and underweighing undervalued stocks.” Since fundamental index strategies tend to outweigh companies that appear cheap based on various financial metrics, they tend to outperform in environments that reward such “cheap” or value stocks. As for their absolute level of performance, fundamental strategies are affected in much the same way and by the same factors as large company stocks.
Fundamental index strategies may lag market-cap indexes in “boom” or “momentum” periods, or when the biggest companies (as measured by market capitalization) dramatically outperform the smaller companies in an index.
Small company stocks—or “small caps”—are investments in the equity of smaller companies, generally those that represent the bottom 10% of the market by cumulative market capitalization. Small company stocks may provide greater potential for growth than large company stocks. However, they are riskier because their size makes them more vulnerable to economic shocks, inexperienced management, competition and financial instability.
The small company stocks offer higher growth potential than many other asset classes because of the potential for such companies to grow rapidly. Small cap stocks have higher expected long-term returns relative to other asset classes to compensate for the higher risk associated with them.
Small company stocks generally perform well when the economy is expanding or investors expect such expansion to occur. Small company stocks tend to be more closely tied to the strength of the domestic economy than large company stocks because they typically generate most of their revenue within the territory, while large, multinational companies often generate a substantial portion of revenue in multiple geographies around the world. Valuation matters as well. When prices are low relative to, for example, earnings and subsequent prices, performance is likely to be stronger.
During extreme equity market or economic stress, these stocks tend to perform poorly. When prices are high relative to earnings, price performance can suffer.
Emerging market stocks are equity investments in companies domiciled in countries with developing economies experiencing rapid growth and industrialization. Emerging markets differ from their developed market counterparts in four main ways: (1) They have lower household incomes; (2) They are undergoing structural changes, such as modernization of infrastructure or moving from a dependence on agriculture to manufacturing; (3) Their economies are undergoing development and reform programs; (4) Their markets are less mature. Emerging markets are riskier than developed markets due to greater potential for political instability, currency fluctuations, an uncertain regulatory environment, and higher investment costs.
Emerging markets offer a unique combination of benefits: (1) Higher growth potential than developed markets. For investors, this is important because corporate revenues have the potential to grow faster when economic growth is higher. (2) Diversification. By investing in emerging markets, diversification increases as emerging markets can perform differently than developed markets. (3) The potential to discover up-and-coming companies.
Emerging market stocks generally perform well during periods of faster growth when commodities are trading at relatively high levels, local export markets are thriving due to a growing economy, and local governments implement policies more conducive to private sector growth. Valuation matters as well. For example, when prices are low relative to earnings, subsequent price performance is likely to be stronger.
Emerging market stocks typically struggle when developed countries are in a recession or experiencing a slow-growth environment. Also, due to their relatively high dependence on commodity sales, they typically don’t perform well when commodities are experiencing declining prices. Periods of high geopolitical risk are also harmful for emerging market stocks. When stock prices are high relative to earnings, price performance can suffer.
Nimble analysis is required to avoid potential pitfalls among emerging market equity ETFs. Sparkasse Emerging Markets Equity and iShares Core MSCI Emerging Markets both provide exposure to a diversified group of countries, unlike some funds which limit exposure to a single region or have a high concentration in one particular country. Furthermore, these are large ETFs with more than kr 5 billion in AUM each at the time of ETF selection. Each of these ETFs had low operating expense ratios at the time of ETF selection and have historically traded with relatively narrow bid-ask spreads (less than 0.05% in a category where spreads can be as high as 1%).
Vanguard FTSE Emerging Markets ETF is the largest ETF in this category and had expense ratio equal to iShares Core MSCI Emerging Markets, the secondary ETF, at the time of ETF selection. However, it was not selected as the secondary ETF because of its higher tracking error vs. the primary ETF in this asset class. iShares MSCI Emerging Markets is the third largest ETF in this category but had an expense ratio 56 basis points higher than the primary ETF at the time of ETF selection.
Government bonds are debt instruments issued by a government in a highly developed country. They may be issued at the home currency of the country of origin, or denominated in U.S. dollars or other currency. They have various maturities, from one year or less to as long as 30 years. They generally pay interest on a semi-annual basis, and timely payment of principal and interest is backed by the full faith and credit of the government, making them among the highest credit-quality investments available. Yields on government bonds are usually lower than for most other bonds because investors are willing to accept less income in exchange for lower risk. While these bonds are generally considered free from credit risk, they do carry interest rate risk—all else being equal, their prices increase when interest rates fall and vice versa.
Since government bond are considered to be essentially free of credit risk, they provide a secure and predictable source of income, and can be a means of preserving capital. Money that investors want to keep safe from default and stock market risk is often invested in government bonds. The market for government bonds is large and liquid, which means that investors can easily buy and sell the securities when they want. By keeping a portion of the portfolio’s assets safe, an allocation to government bond in an overall portfolio may allow an investor to take risk in some other part of the portfolio with more confidence. Finally, government bonds provide diversification from stocks in a portfolio. They often move in the opposite direction of stocks, particularly when the economy is weakening and/or when stocks are falling.
Government bonds tend to perform best when inflation is low and interest rates are falling, like all bonds. However, they also tend to outperform other types of bonds, on a relative basis, when market volatility is high, when the economy is weakening, and stock prices are falling. Investors often put money into government bonds as a perceived safe haven during times of economic and/or geopolitical turmoil due to the high level of safety and liquidity.
Government bonds tend to perform poorly when inflation and interest rates are rising and market volatility is low. If investors perceive that the economic and financial environment is low risk, then government bonds are seen as less attractive to hold than other types of investments, such as corporate bonds or stocks. The lower yields for government bonds make them less attractive to investors when risk and market volatility are low.
Investment grade corporate bonds are investments in the debt of corporations with relatively high credit ratings provided by one or more of the major international credit rating agencies. Investment grade corporate bonds are those rated BBB- or higher by Standard and Poor’s, or Baa3 or higher by Moody’s Investors Services. These high ratings indicate that these bonds have relatively low default risk, and, as a result, the bonds generally pay a lower interest rate than debt issued by entities with below-investment-grade credit ratings. These bonds always pay higher interest than bonds issued by governments of developed countries, all else being equal.
Investment grade corporate bonds can allow investors to earn higher yields (with more credit risk) than more conservative investments like government bonds, with lower credit risk than that of sub-investment grade, or “high yield,” corporate bonds. Credit risk is the risk that a borrower will fail to meet a contractual obligation, resulting in a loss of principal or interest. The higher yields that investment grade corporate bonds offer as compared to government bonds can help enhance the overall return of a fixed income portfolio. Investment grade corporate bonds also offer diversification benefits. The investment grade corporate bond market is massive, with hundreds of issuers and thousands of individual issues, allowing investors to diversify by issuer, industry, maturity and credit rating.
Investment grade corporate bonds tend to perform well when the economy is growing and default rates are low and are expected to stay low. In addition to the higher yields that corporate bonds offer, investment grade corporate bonds can appreciate in price as well. The yield advantage that corporate bonds offer, relative to government bonds, is called a credit spread; it can be thought of as compensation for the extra risks they carry. If the economic outlook is strong or default rates are expected to remain low, investors may accept lower compensation, as the perceived risks of default may decline. When the credit spread falls, the price of corporate bonds generally rises relative to government bonds.
Investment grade corporate bonds tend to perform poorly if economic growth slows and defaults are expected to rise. Even though investment grade corporate bonds tend to default significantly less than high yield corporate bonds, investors may demand higher yields to compensate for the potential for a higher rate of corporate defaults. As a result, yields tend to rise relative to government bonds, pushing prices lower. During periods of market distress, investment grade corporate bonds are generally less liquid than government bonds, which could exacerbate price volatility.
Emerging Market (EM) bonds are issued by a government domiciled in a developing country. These investments typically offer higher yields to reflect the elevated risk of default, which can stem from underlying factors such as political instability, poor corporate governance and currency fluctuations. This asset class is relatively new compared with other sectors of the bond market. Indices that track EM bonds only date back to the 1990s when the market became liquid and actively traded. While some international EM countries have taken on the characteristics of developed market economies with more stable fiscal and monetary policies and sounder financial institutions, there remain wide differences among the countries categorized as emerging markets.
An allocation to EM bonds can provide investors with a source of higher income than developed market bonds might offer and the potential for capital appreciation. The potential upside, however, comes with more risk. Defaults among EM bonds have historically been higher than for developed market bonds. EM bonds tend to be more highly correlated with equities than with developed market bonds. EM currencies also tend to be much more volatile than developed market currencies. Corporate bonds issued by companies in EM countries can offer access to fast-growing economies with higher yields than what might be available in developed market corporate bonds.
EM bonds tend to perform well when major currencies like the US dollar, euro or Japanese yen decline because EM assets look more attractive by comparison. A growing global economy tends to benefit EM country bonds as well since exports generally represent a bigger proportion of EM economies. A low interest rate, low volatility environment has also tended to be positive for EM bonds because investors are attracted to the higher interest rates EM bonds offer.
In addition to the factors that contribute to the poor performance of developed country bonds, EM bonds tend to perform poorly when investors are averse to taking risk or when global growth slows. Since many EM countries derive much of their growth from exports to developed countries, slower growth in trade globally tends to be a negative factor for the economies and currencies of EM countries.
Precious metals include gold, silver, platinum, and other precious metals.
This asset class adds diversification to a portfolio and is typically considered defensive because of its tendency to perform well when financial assets (e.g., stocks and bonds) perform poorly.
Precious metals tend to perform well when expectations for future inflation are increasing, the major currencies are falling, geopolitical unrest is rising, or there are widespread concerns about the stability of the financial system.
Precious metals tend to perform poorly when expectations for future inflation are decreasing, the major currencies are rising, geopolitical unrest is falling, or concerns about financial system stability are declining.
Diversification, automatic investing and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. PSS Portfolio Builder is designed to monitor a client’s portfolio on a daily basis and will also automatically rebalance as needed to keep the portfolio consistent with the client’s selected risk profile, unless such rebalancing may not be in the best interest of the client. Trading may not take place daily.
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