An Overview of Equity Asset Classes
When you buy a fixed rate bond issued by a company, the cash flows you will receive in the future (assuming you hold the bond to maturity) are known: you will receive the coupon rate of interest, plus the face value of the bond. As we have seen, only two circumstances could change this. First, you could choose to sell the bond before its maturity. In this case, rather than receiving the face value of the bond, the amount you will receive in general will depend on the relationship between current interest rates and the coupon rate on the bond. If current rates are higher than the coupon, you will receive less than face value, but if they are lower you will receive more. The second source of uncertainty is the chance that the company that issued the bond will experience financial problems and default on the payments it owes you.
In contrast to bonds, the payments you expect to receive when you purchase a share of common stock (i.e., an equity) are much less certain. In essence, a share of common stock is claim on what is left of a company’s cash flows after everyone else that is owed money has been paid (e.g., suppliers, workers, taxes, bondholders, etc.).
For example, while you know the current dividend paid on each share of stock when you buy it, there is no guarantee that this dividend will remain the same in the future. Depending on the company’s business success, the cash available to pay it may increase or decrease. And the company may choose to do something with it other than paying dividends. Alternatively, it could use it to buy back some of its shares (which in some countries is more tax efficient than paying dividends), or it could invest the cash to expand its business.
In addition, the market price of the share itself will fluctuate in the future. Broadly speaking, five factors combine to determine the future price of a share you buy today. First, there is the current dividend paid, which is the cash flow you expect to receive in the short term as a result of owning the share. Second, there is the rate at which these dividends are expected to increase in the future. The next two factors determine the rate at which these future cash flows are discounted back to their present value today. The third valuation factor is the current rate of interest on government bonds (also known as the “risk free” rate), and the fourth is the extra amount of return investors require to induce them to invest in risky equities instead of risk free government bonds. This extra amount is known as the “equity risk premium”. Taken together, these first four factors are often said to determine the “fundamental” or “rational” value of a share of equity.
However, as anyone who experienced the Japanese equity bubble in the 1980s or the internet bubble in the 1990s is painfully well-aware, rational factors aren’t the end of the story when it comes to determining equity prices. Hence our fifth factor: investor emotions. There are times when equity prices, either of a single share or of a market as a whole, rise to levels that are difficult (to put it mildly) to justify based on reasonable estimates of our first four factors. These are the times when momentum tends to be the key factor determining current share prices – in other words, people’s belief that share prices will increase in the future simply because they have done so in the past, without any reference to the changes in the fundamental factors that would justify (or undermine…) those beliefs.
Of course, such attempts are sometimes made – who during the tech boom didn’t read an article claiming that future growth rates would be incredible, or that the equity premium was now close to zero? With respect to domestic equities as an asset class, the key point to make is that while these statements may occasionally be true for individual shares (e.g., Microsoft in 1985, or Apple in 1997), they are essentially never for an equity market as a whole. For example, while rapid real growth in dividends might be expected for an economy emerging for a war, equities would probably still be quite risky under these circumstances.
Alternatively, if I knew a big increase in inflation was coming, and could only invest in equities or nominal return fixed rate bonds, the real equity risk premium might decline (based on the assumption that equities would do better than bonds under these circumstances). However, there would be no reason to expect the growth of dividend payments to also rapidly increase (as real economic growth tends to fall during periods of high inflation).
The bottom line is this: domestic equities are riskier than many other asset classes, and as such should generally produce higher returns in normal times, and lower returns in difficult times.
Foreign Developed Markets Equity
As was true in the case of bonds, investors can invest not only in their domestic equity markets, but also in the equity markets of other countries. Broadly speaking, these international equity markets can be divided into two asset classes: equity markets in developed countries, and emerging equity markets in less developed countries
In today’s world, the correlation of returns between developed country equity markets is significantly higher than it was in the past, to the point that it is questionable whether they are really a distinct asset class, based on our criteria. This is particularly true when you net out the portion of returns on foreign developed equity markets that is due to exchange rate gains (which can also be obtained from investing in foreign government bonds, which have better portfolio diversification benefits).
On the other hand, for investors in many countries there is still an argument for investing in foreign developed country equity markets, in order to gain exposure to industry sectors that are underrepresented in their home market (relative to their weight in the global equity market).
Of course, this begs the question of whether it wouldn’t just be easier and cheaper to simply treat developed country equities as a single asset class. On balance, we tend toward the view that while in the past it made sense to treat foreign developed market equities as a separate asset class, today it probably does not.
Emerging Markets Equities
As an asset class, emerging market equities (including the new category of “Frontier Markets”) offers the potential for higher returns than foreign (developed market) equities, though at the price of higher risk. Their higher return potential is driven by rates of both labor force and productivity growth that should be higher (sometimes considerably so) than comparable rates in more developed countries.
On the other hand, emerging markets also tend to have (and these are broad generalizations), less stable political systems and economies than developed markets. Consequently, the returns on emerging markets equity investments are more volatile than those on developed markets equities.
To be sure, in the low volatility environment that has prevailed in recent years as a result of central banks very aggressive monetary policies, the correlation between emerging and developed market equity index returns has risen above our traditional cut off point for defining separate asset classes. However, the underlying economic, social, and political distinctions have not changed. Hence we expect correlations to decline again once we see a return to more normal monetary policies. For this reason, we continue to view emerging market equities as a separate asset class.
As the name implies, this “private equity” encompasses investments in the equity of companies that are not publicly traded. These investments are usually made through a professionally managed fund (often a limited partnership), which serves as the intermediary for searching out, evaluating, and monitoring the private equity investments.
In general, there are two sub-classes of private equity: venture capital funds and buyout funds. Traditionally the former made a large number of small investments (relative to the size of the fund) in companies that are in the early stages of development, and with prospects for high future growth. However, in recent years the VC model has evolved, with fewer exits via initial public offerings (IPOs) of portfolio companies, and more “later round” investments in companies that have grown quite large while still remaining private.
In contrast to traditional VC funds, buyout funds typically leveraged investors' money with debt, and make a small number of large investments to take established public companies (or parts thereof) private. Traditionally, buyout funds eventually took their portfolio companies public again. In recent years, however, the industry has seen a rising number of company sales from one private equity fund to another.
The underlying economics of venture capital and buyout funds are quite different. Venture capital funds historically lost money on most of their investments, and earned their returns on just a few "big winners" whose rapid growth (or expected growth) enticed buyers to pay high prices for their shares.
In contrast, buyout funds expected to make money on all their investments. Their strategy was to increase the free cash flow (cash flow after capital investment) of the companies they purchased. Most often, this was accomplished through cost cutting and asset sales, rather than by stimulating faster sales growth. Greater free cash flow was used to support higher debt levels, which often funded large payouts to PE funds in advance of an IPO or trade sale. In recent years, however, as companies across the economy have been run with much greater efficiency, private equity strategies have broadened to include both organic and acquisition led growth.
Historically, a major problem in evaluating the relative attractiveness of the private equity asset class has been the lack of available and reliable data on its risk and returns. The essence of the problem is that the actual return earned on an investment in a private equity fund isn't known with certainty until the fund is liquidated (usually after ten years). Before then, estimated returns are based on the valuation of the fund's investments, which is at best a very uncertain science.
Research has found that returns on private equity are quite skewed, with top quartile managers performing much better than others.
Moreover, private equity returns have a high correlation with return on public equity markets. In essence, any private equity returns earned above those on domestic equity reflect compensation for holding an illiquid investment for ten years, as well as the risk associated with picking a poor investment manager.
The cost investors pay to access private equity investment (i.e., fund manager fees) are much higher than the cost to access public equity markets. This raises the question of whether investors in private equity are actually being adequately compensated for the illiquidity risk and equity risk they are bearing, after taking fund managers' high fees into account.
Finally, research has also shown that the more money that is raised by private equity funds in any given year (known as the "vintage year" of the fund), the lower the returns that will likely be earned on those funds (e.g., due to private equity managers bidding up the price of potential investments, a phenomenon known as "pricing for perfection").
On balance, we view private equity as a possible sub-allocation within the broader equity asset class, whose potential to outperform public market equity (net of fees) is highly uncertain.
Now let's move on to commercial property, commodities, and active uncorrelated alpha strategies.