Tuesday, May 19, 2009

Asset classes and the inadequacy of labels - Alpha

Labels and bad jargon can lead to cloudy thinking and poor investing. Or as Orwell wrote: “the slovenliness of our language makes it easier for us to have foolish thoughts.” The institutional investment world, by consensus, labels asset classes such:

-Absolute Return
-Fixed Income
-Private Equity
-Real Assets (Real estate and commodities)
See the investment report for the Yale Endowment and its chief Dave Swensen’s book “Pioneering Portfolio Management.”

I posit that the traditional scheme of labels is an unhelpful way to view the investible universe. A better way would be to look at the economic and legal structure of investments, and draw out broader, more conceptual categories. Basically, there are four types of claims: real, fixed, residual, and derivative. All stocks, bonds, absolute return strategies, and other financial instruments can be viewed as being in these buckets.

Real claims: This is direct ownership of, and often physical possession of, tangible assets. This means owning hard assets like gold, land, oil fields, oil barrels, wheat, etc. Most homeowners have a real claim on their home; they both own it and reside in it. Physical ownership and control is important for unstable societies (e.g. owning oil fields, pipelines, and ports in Nigeria, with one’s own security forces to guard these assets since the government and police are weak and unhelpful). Value comes from using up an asset: selling the land, drilling for oil and depleting the field, etc.

Fixed claims: This is a fixed monetary claim on the earnings of an asset or entity. Bonds are fixed legal claims against a company or government entity’s earnings or balance sheet. The debtor must pay a certain amount (interest) periodically to the creditor, and when the period is over the whole sum (principal) must be returned. Sometimes fixed assets are secured with real assets, sometimes not. When owning fixed assets, a strong legal framework and rule of law is important. If a creditor can’t trust the court system to collect from a defaulted debtor, this asset class becomes much riskier. Very safe real estate that pays out a steady annual income falls between a real claim and a fixed claim.

Residual claims: This is a residual monetary claim on the earnings of an asset or entity, coupled with some sort of ownership of the asset or entity. Often residual claims are in common stock or partnership interests. Preferred stock and convertible bonds are hybrids between fixed and residual claims. The distinction between public equities and private equity both is and isn’t important (we call that a paradox). Public equity owners have little control over a firm’s residual resources, a small ownership stake, and a liquid market for their stake. A private equity owner has much control over a firm’s residual resources, a large ownership stake, and an illiquid market for their stake.

Derivative claims: This is a structured contractual claim whose payout depends on the price or level of another “reference” entity from point 0 to point 1 in time. Futures, options, and structured products are derivatives, and the underlying reference entity can be real assets like gold, bonds, stocks, interest rates, commodities, indexes, and pretty much anything (weather, political outcomes, catastrophes, etc.). This is raw betting, sometimes hedging.

My thesis is that an investor must have a different skill set for each of the asset classes above.

For real claims, the productive or final sale value of the asset is key. At the purest, non-speculative level, investors in real assets are like 19th century entrepreneurs, attempting to turn land into cities, forests into timber products, and deserts into productive oil fields. The premium skill set here is resource conversion. Can the real claim owner turn silk fibers into textiles people want, or trees into furniture?

For fixed claims, coverage and security are key. That is, does an entity have the earnings to “cover” both the interest and principal payments? Analyzing the factors behind earnings, like profitability, firm size, return on assets, etc. is important. And as extra security, if the payouts are missed, can the fixed claim owner recover some value through secured real claims on hard assets? The premium skill set here on engineering analysis and character appraisal. What is the margin of safety on cash flow variation, and can the fixed claim owner trust the debtor to not default?

For residual claims, growth prospects and final payouts are key. Common stock holders want to know if they will ever get any of the residual cash generated by an entity. Of course, investors can sell their shares, but at some point, some final investor must get cash flows or a distribution of hard assets. Otherwise, the whole thing has been a sham, a game of musical chairs with no prize at the end. For a residual claim, there is no obligation for an owner to ever get anything. The premium skill set here is on economic analysis and character appraisal. What are the growth prospects for a business over time, and can the residual claim owner trust management to act in her best interest in distributing cash before doomsday? Value stock investors do more of a fixed claim analysis (is the stock trading for less than its assets?). Growth stock investors do more of a residual claim analysis (will enough cash be generated in the future to elevate the stock?). Distressed debt investors do a complicated mixture of fixed and residual claim analysis: fixed when they look at liquidation values and collateral; residual when they look at the worth of a business over time, and their potential future ownership share.

For derivative claims, a keen understanding of both the underlying security and the technical features of the derivative contract are key. To trade natural gas, one needs to understand the underlying supply and demand in the market (like a real claim owner), along with the quirks of the trading environment and the features of the contract (the roll date of the contract, its liquidity, etc.). Also, knowledge of a counterparty’s solvency is important, as a derivative claim owner could win on a trade and lose when the other side goes bust and fails to pay.

In the end, this classification scheme really gets to the heart of investing. In comparison to the conventional wisdom above, it combines “equities” and “private equity” into one class. It eliminates “absolute return,” which is a marketing buzzword that sells the idea that any investor or class can always be up and never down. And this scheme unmasks derivatives as their own world, a separate asset class which must be handled carefully or completely avoided.

One final note, which Vega points out:
“There's also the problem that the asset categories [describe above] can be manipulated: fixed claim investments can act as derivatives if they're at a deep enough discount and bought with leverage; then they effectively become call options. Investors in real estate in 2006 were more similar to equity speculators (looking to sell at a better price rather than collect any cash flow), than ‘19th century entrepreneurs.’”

Vega has a point. An equity position in a near-bankrupt company is more like a call option, a derivative claim. Likewise, distressed debt in an over-levered company is more like equity, a residual claim. For capital structure arbitrage, an investor is arbing the perceived relative value differential between a fixed claim and a residual claim (or fixed to fixed, fixed to derivative, etc.). A final example: when investors borrow much money to buy any hard asset, with the goal of flipping the assets months later, their position is more like a derivative claim than a real claim. The point is to look at the substance of a security/asset and its situation, not the outward label (bond, stock, real estate, etc.).


  1. This comment has been removed by the author.

  2. This is really interesting stuff! Is it original or do you have some references? It would have to be in the Swensen book you quote, because the Yale report seems to use the traditional classification.

  3. Hi Chris,

    I believe Alpha's method for classifying investments is original, at least as an alternative asset classification approach.