For financial professionals only
Understanding Asset Classes: know what you have, and why you have it
This article forms the second in a series on asset classes. It’s easy to break down portfolio structure to simply diversifying between defensive and growth assets to deliver the appropriate balance of risk and return for your client’s chosen risk profile. But in this series, we dig deeper into our expectations of each class, and how we use those key characteristics in our different solutions.
If you’ve followed the stock market this year, you may well have a view that in the first quarter everything went down, in the second everything went up and after that it all went a bit flat….and that’s roughly accurate.
It makes sense, too – a global pandemic is by nature, an event that impacts everyone, so it was unlikely any major equity market was going to be left unscathed.
But whilst this general down/up view might be fair, it’s worth looking more closely at the variability we’ve seen across asset classes and regions. Several factors contribute to the way different equity markets might react to the same event. And it’s within these differences that the value of a tactical approach to investing is often found.
A defensive character
We can explore this quite neatly by comparing Japan with its neighbours. Proximity of location doesn’t necessarily translate to proximity of character. It’s fair to consider Japan a much more developed economy and stock market. Whilst much smaller now, at its peak Japan represented 45% of the global index. Versus a less developed counterpart, this will generally provide a degree of relative defensiveness – or put another way, a lower beta. When markets move up or down, Japan will generally move less. Other factors can play a part here too; the degree of exposure to certain sectors or even the corporate attitude of businesses. Japanese stocks often hold much higher cash balances, for example.
A currency cushion
For overseas investors in Japan, currency has an important impact on the profile of returns too. The Yen is often viewed as a “safe haven” currency; in times of stress or uncertainty increased demand for the currency can mean its value goes up. A UK investor’s return on a Japanese stock in their portfolio is a multiple of the return of the actual stocks and the Sterling/Yen return over the same period (putting currency hedging to one side). If Yen goes up, it means more pounds received when translated back. This currency boost – often experienced in tougher equity market conditions – is another key reason Japan can be seen as a more defensive market. It has a natural cushion built in.
Looking through the cycle
Of course, you can’t have it all your own way and this protection in one direction can manifest as a headwind when markets go the other way. But it’s these kind of traits that can help us decide which equity markets we want more exposure to, based on our expectations of what’s to come and where we think we are in the business cycle. Many of our Tactical Asset Allocation Committee meetings are spent discussing this – alongside other important factors such as valuations and sentiment.
Having a good idea of how different equity markets will behave under different conditions is fundamental to adding value to a client’s portfolio – importantly from both a risk and return perspective – even when on the surface it may just seems like it’s “everything down, everything up”.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.