Gone are the days when investors had only the broad categories of equities, bonds, cash and real estate for their asset allocation. Of late, a group of several investable asset classes, referred to collectively as alternative investments, has gained more prominence. Alternative investment asset classes include hedge funds of various types, private equity funds, managed or passively constructed commodity funds, artwork, and intellectual property rights.
One can further divide equities by whether the issuing companies are domestic or foreign, large or small, or whether they are traded in emerging or developed markets. However, one needs to consider the constraints on investments before deciding on which asset class he plans to park the money. Let us discuss some important investment constraints.
Liquidity refers to the ability to turn investment assets into spendable cash in a short span of time without having to make significant price concessions to do so. The best way to find the liquidity of an asset class is to determine how long it would take to arrive into your pocket if you happened to need it today. One needs money to pay tuition, to pay for medical expenses or to fund other possible spending that requires holding of some liquid assets. Illiquid investments in hedge funds and private equity funds, which typically are not traded and have restrictions on redemptions, are not suitable for an investor who may unexpectedly need access to the funds.
In general, the longer an investor’s time horizon, the more risk and less liquidity the investor can accept in the portfolio. While the expected returns on a broad equities portfolio may not be too risky for an investor with a twenty year investment horizon, they likely are too risky for an investor who must fund a large purchase at the end of this year. For such an investor, government securities or a bank certificate of deposit may be the most appropriate investments because of their low risk and high liquidity at the time when the funds will be needed. While the investment in stock and bonds can be risky in the short run, time has a moderating effect on market risk.
Besides an individual’s overall tax rate, the tax treatment of various types of asset classes is also a consideration in security selection and portfolio construction. For instance investors who are in the higher tax brackets may prefer tax-free bonds to taxable bonds or prefer equities that are expected to produce capital gains, which are often taxed at a lower rate than other types of income like dividends. A focus on expected after-tax returns over time in relation to risk should correctly account for differences in tax treatments as well as investors’ overall tax rates. Some types of investment such as provident fund or new pension schemes may be tax exempt or tax deferred. Similarly, investment in different types of mutual funds such as equity fund, debt fund, arbitrage funds, gold funds, etc.
In addition to financial market regulations that apply to all investors, more specific legal and regulatory constraints may apply to particular type of investor. Trust, corporate, and qualified institutional investors are restricted by law from investing in particular types of securities and assets. There may also be restrictions on percentage allocations to specific types of investments in such investors.
Each investor, whether individual or institutional, may have specific preferences or restrictions on which securities and asset classes they can invest. Ethical preferences, such as prohibiting investment in securities issued by companies in the manufacturing or distribution of tobacco, alcohol, defence, firearm producers and environmental harmful products are not uncommon. Restrictions on investments in companies or countries where human rights abuses are suspected or documented would also fall into this category. Religious preferences may preclude investment in securities that make explicit interest payments. Unique investor preferences may also be based on diversification needs when the investor’s income depends heavily on the prospects for one company or industry. Sometimes, an investor who has founded or runs a company may not want any investment in securities issued by a competitor to that company.
One need to keep in mind the above investment constraints before actually embarking into asset allocation process.
Alternative investment asset classes include hedge funds of various types, private equity funds, managed or passively constructed commodity funds, artwork, and IPRs
One can further divide equities by whether the issuing companies are domestic or foreign, large or small, or whether they are traded in emerging or developed markets
The best way to find the liquidity of an asset class is to determine how long it would take to arrive into your pocket if you happened to need it today
Liquid investments in hedge funds and private equity funds are not suitable for an investor who may unexpectedly need access to the funds
Each investor, whether individual or institutional, may have preferences or restrictions on which securities and asset classes they can invest
The writer is associate professor of finance & accounting, IIM Shillong