Asset Subclass Risk-Return Profile

The core asset classes have general risk-return characteristics.

The greater an investment’s risk, the greater the demanded return by investors.

Cash is low risk, low return. Fixed income is riskier and has higher returns than cash. Common shares have the highest risk and expected return of the core asst classes.

But you need to exercise care when selecting investments within a specific asset class. There can be significant fluctuations in risk-return profiles between investment options in each class.

We will look at a few examples today.

Cash and Cash Equivalents

In general, cash equivalents are considered low risk and low return assets. They are known for their safety and liquidity.

But not all cash equivalents fit this profile.

For a U.S. resident investing in short-term U.S. Government Treasury bills, those characteristics hold true.

High Risk Countries

But the Venezuelan bolívar is also cash. For a U.S. resident investing in bolívar during 2018, the hyperinflation in Venezuela made this currency worthless.

Or consider the Argentina peso. In 2001, the government effectively froze bank accounts for a 12 month period. In large part, liquidity and safety disappeared almost overnight. As an added bonus for Argentines, prior to January 2002 the peso was pegged to the U.S. dollar (USD) at a 1:1 ratio. Then one day Argentines awoke to find the conversion rate re-pegged at 1.4:1. Within short order that re-pegging had fallen to about 4 pesos per U.S. dollar.

What did that mean?

If you bought a USD 600 television imported from America, it cost 600 pesos in December 2001. Less than a year later that same purchase cost 2400 pesos.

Be careful of countries that have a high risk of heavy inflation or the potential for intentional currency devaluation.

Even Low Risk Countries

If you think it is simply countries such as Venezuela and Argentina that need watching, check out the 10 year exchange rate changes between the U.S. and Canadian dollars. Or the USD and the Euro. Or other major currencies. There can be some large swings in exchange rates.

For example, I was living in Switzerland when the Euro was introduced. In 2001, the Euro was usually worth between USD 0.80 and 0.90. By late 2004, each Euro was worth USD 1.36. If you were an American and had bought Euros in December 2001 at 0.88, by December 2004 you would have earned a 55% return.

And if you were living in Euroland and had invested in USD between those years, you would have lost a lot of money.

Two highly regarded currencies. Yet not a low risk, low return investment, was it?

When investing internationally, whether to hedge your foreign currency is always a concern. There are pros and cons to hedging (or not). What is preferable for one investor will differ from the next. And there are multiple variables that require consideration before deciding if hedging is right for your portfolio.

Fixed Income

Fixed income securities are generally considered to be higher risk and higher return than cash equivalents. But lower risk and return to common shares.

Yet again, individual fixed income securities can differ from this generality.

Credit Rating

Fitch Ratings classifies the “safest” bonds at AAA. Lowest investment grade bonds are BBB. Bonds in default are rated D.

As you would expect, the higher the bond rating, the lower the risk of the bond not paying interest on its debt and in the repayment of principal. The lower the risk, the lower the interest that is needed to attract investors.

Conversely, the greater the risk that the bond issuer will be unable to pay the interest and principal, the more incentive is required to attract investors. That incentive could involve “sweeteners”, though often it is simply offering higher yields.

For example, consider four bonds, maturing in 18 years, with no sweeteners or provisions. Data as at February 26, 2019.

Government of Canada 5.00% 01-Jun-2037 are rated as AAA. The yield to maturity (YTM) is 2.074%.

Hydra One Inc. 4.89% 13-Mar-2037 are rated as A (High). The YTM is 3.628.

Bell Canada 6.17% 26-Feb-2037 are rated as BBB (High). The YTM is 4.258%.

Shaw Communications Inc. 6.75% 09-Nov-2039 are rated as BBB (Low). The YTM is 4.834.

You can readily see, as the risk of default increases, the yield to maturity required by investors also rises.

Equities

Of the three core asset classes, common shares traditionally have the highest risk and return.

But this may not always be true.

Other Asset Classes May Outperform

We looked at some fixed income yields above. Assuming a hold until maturity, yields between 2% and 4.8%. Relatively safe, but also relatively low return.

What if we compare this to Canadian equities?

On February 27, 2018, the TSX Composite closed at 15,671.15. On February 25, 2019, it closed at 16,057.03. A one year return of only 2.68%. Lower return than many bonds, yet much higher risk.

Of course, one year is a very short time frame. Too short to properly assess higher risk assets. Over the 10 years ended February 25, 2019, the TSX Composite earned investors more commensurate average annual returns of 7.31%.

Never focus on short term performance for higher risk investments.

Differences Within the Class

Of the three core asset classes, there are the most subclasses within common shares.

Mega cap shares will normally have less risk and return than micro or nano cap companies.

Value stocks may be less volatile than growth stocks.

Dividend producing companies may be lower risk than capital appreciation shares.

Foreign companies may have more risk than domestic.

Defensive stocks may be less risky than cyclicals.

Mining companies may be riskier than utilities.

Or, depending on economic conditions, the opposite may be true.

The individual common shares you select will have a different risk-return profile than common shares as a whole.

That is why investors often diversify through multiple subclasses, to spread the risk. Or purchase exchange traded or mutual funds, that usually contain a substantial number of individual investments to diversify risk somewhat.

That is also why some investors try to time the markets. As one subclass begins to outperform, more capital is allocated to that subclass and away from underperforming subclasses. But the ability to time the market is not easy and the transaction costs can be steep. Many investors get the timing wrong and end up costing themselves return.

Okay, that was a few quick examples of how investments within a specific asset class may differ significantly from the general profile for the class as a whole.

There are many other examples possible, but this gives you an idea as to what I am saying.