Thinking Beyond Traditional Stocks, Bonds, and Cash

by Jun 21, 2012Investment Consulting

When constructing an investment portfolio, there are several essential components. What comes to mind for most people are the traditional asset classes: stocks, bonds, and cash. There are, however, numerous investments that are often overlooked. They are known as non-traditional asset classes and strategies.

In order to better understand these asset classes and strategies, it will be helpful to first define what the traditional asset classes are before we discuss the non-traditional.

Stocks.

The first, and probably most familiar, of the three traditional asset classes is stocks. Common stock, also known as equity, represents ownership in a company. The holder of common stock, known as a shareholder, has a claim to part of a company’s assets and earnings. Shareholders participate in the success or failure of the company. If the company does well, shareholders will see the value of their investment increase over time. In addition, if the company pays a cash dividend, shareholders are entitled to receive a portion of that distribution.

Bonds.

The second of the three traditional asset classes is bonds. A bond is a loan and the holder of that bond is the lender. There are two components to a bond: principal and interest. Principal is the amount borrowed, or the amount still owed, on the loan. Interest is the reward the bondholder receives, and the lender pays, for the use of the funds. Bonds can pay interest periodically (usually twice per year) or at maturity. The term of a bond, or length of the loan, can range from a few weeks to upwards of 100 years. Traditional bonds are often referred to as “core bonds” and would include investment grade bonds issued by corporations (e.g., AT&T), government agencies (e.g., Fannie Mae), sovereign governments (e.g., the United States), and municipalities (e.g., New York State).

Cash.

The third of the three traditional asset classes is cash and cash equivalents. Cash is most often thought of as currency such as coins and paper money. It also includes the balances in checking and savings accounts. Cash equivalents are investment securities that are considered highly liquid, very short term, and have a high credit quality. Examples would include money market mutual funds, commercial paper, treasury bills, and short-term municipal notes.

Non-traditional asset classes.

Non-traditional asset classes and strategies lie outside of the traditional stock and bond portfolios. They include non-core (riskier) bonds, commodities, real estate, and alternative strategies. Below, we examine each of these examples in more detail.

Non-core bonds.

Non-core bonds are riskier bonds that tend to fluctuate more than traditional core bonds. These investments are characterized by increased credit risk, increased volatility, and the potential to fall in value during times of panic or large sell offs in the stock market. To compensate for the increased risk, non-core bonds tend to pay higher interest rates than traditional core bonds. Examples of non-core bonds include high yield corporate bonds, emerging market debt, and multi-sector bond strategies.

Commodities are physical items that have economic value such as oil, gold, or corn. Unlike traditional stocks and bonds, commodities do not provide a claim to an ongoing stream of revenue. Instead, they derive their value from their use. Consumable commodities such as corn or wheat can be used as a food source for humans as well as livestock. Transformable commodities such as crude oil, which can be converted into gasoline and plastic, are converted into materials used in everyday products.

Real estate.

Real estate is land plus anything permanently affixed to it, such as residential, commercial or industrial buildings. There are three main ways to invest in real estate.

  1. The direct purchase in one or more properties – you operate the real estate yourself or through a property manager.
  2. The purchase of an interest in a real estate limited partnership – as a limited partner, one would not have any kind of management responsibility nor would one have input into the decision making process. In contrast, the general partner would be responsible for purchasing and operating properties.
  3. The purchase of a share in a publicly traded real estate company or REIT – you are investing in a company that owns real estate and manages it on your behalf.

Alternative strategies.

The final category, alternative strategies, is somewhat more difficult to explain. As its name implies, it is the strategy or process the manager employs that separates it from traditional stock and bond investment managers. An alternative strategy manager will hold traditional asset classes (stocks, bonds, and cash) but in a unique way. Traditional managers gain their primary economic and risk exposures by the type of asset they invest in (large U.S. companies, small U.S. companies, foreign companies, emerging market companies, etc.). An alternative strategy manager’s risk and return exposure is defined more by a trading strategy than by the particular securities held at any given point in time.

Furthermore, an alternative strategy manager may utilize additional tools such as short sales or option contracts where traditional managers will not. These tools can be used for both speculative as well as hedging purposes. For example, a manager could utilize short sales in hopes of profiting from declining stock prices (speculative trades) or utilize option contracts as a form of insurance to limit losses during stock market declines (hedging).

Within the broad category of alternative strategies, there are several different approaches, each with different risk / return profiles. A few examples would include: long / short equity, equity market neutral, global macroeconomic, merger arbitrage, convertible arbitrage, fixed income arbitrage, and tactical asset allocation. As such, when selecting an alternative strategy manager, it is important to understand their particular approach and the risks / rewards involved.

Now that we have defined non-traditional investments, we can discuss why they are useful in a diversified portfolio. Historically, non-traditional asset classes and strategies have behaved differently than traditional stocks and bonds. With different risk and return characteristics, these investments tend to be less sensitive to movements in the general stock market. Therefore, adding non-traditional investments to a portfolio can reduce portfolio volatility and improve risk- adjusted returns.

In closing, I hope you now have a better understanding of what non-traditional investments are and why they are useful components of your portfolio.