The primary Investment Asset Classes are Cash and Cash Equivalents, Stocks (Equity), Bonds (Fixed), Real Estate, Commodities, and Alternative Assets. We can argue that there are more or fewer than these, though the arguments are mainly over semantics. There have been countless times in talking to people when they ask "Should not Mutual Funds and ETFs be included as an Asset Class"?
I recall having a brief discussion with my Dad about his investments after I had been working for a few years on Wall Street. He had always kept his investments mainly to himself, as most men seem to do. Talking about one's investments in depth is like asking a woman for directions. Men just do not do such a thing.
I asked him what types of investments he was holding. His immediate answer was Stocks, Bonds and Mutual Funds. When asked about the investment objectives of the Mutual Funds, Dad responded that he did not know. However, it was apparent that Dad viewed these funds as a unique class of investments separate from stocks and bonds.
Dad had invested in these funds since some of his friends were doing the same. For some reason, this conversation has always stayed with me and I have engaged people in similar conversations over the years. Interestingly, many times the responses were much the same as my Dad's response.
Many people appear to think that "Funds" are a unique class of investments that one would invest in along with the other Asset Classes. In other words, people think that Mutual Funds and Electronically Traded Funds ,or ETFs, are an Asset Class in and of themselves. To reinforce this statement, I consistently start the same discussion in every Adult Education Class I teach in various school districts on Long Island.
The results show that roughly 60% of the class participants believe that Mutual Funds and ETFs are an Asset Class distinct from Stocks and Bond investments.
Mutual Funds, ETFs and any other Type of Fund
Funds of any kind are merely a co-mingling or grouping of investments in the Asset Classes mentioned above. Funds are not Asset Classes themselves. Funds were started back in the 1940's for a couple of reasons:
- Management - Funds allowed an Investor to have is money managed by a Professional Asset Manager. A single investor does not generally have this ability unless he has sufficient assets to warrant the hiring of a Manager for his portfolio. This has changed somewhat with the advent of Separately Managed Accounts.
- Diversification - The comingling of assets of many investors allows the fund, and each investor, to own many different securities. A single investor buying individual stocks generally does not have this ability unless he has a large amount of money to invest..
Funds are a Means to an End in Investing
A person must decide to either invest his money or hold it in very safe investments such as a Bank Saving Account or CD. Once the person has decided to invest his money and take on more risk, the next decision is which Asset Classes and the proportions of each are suitable for his portfolio. After this most primary decision is made, the investor can focus on how to invest to achieve the investor's objective.
Assuming the investor decides upon Equity Investments, Fixed Investments and Commodities:
- he can open an account at one or a number of Mutual Fund companies and decide which Funds are appropriate based on the investment objective of each Fund. The investor decides which Assets Classes are suitable, but the Manager decides on the selection of the individual securities to be included in the Fund or;
- to achieve efficient level of assets, he could hire an Investment Manager to do everything, including which Asset Classes are suitable based on the Investors objectives. The investor is turning all decision making over to the Manager.
The point is that "Funds" are only a Means to an Investment End. They are a way or method of investing in Asset Classes such as Stocks, Bonds, and Commodities. Each Fund has a specific Investment Objective which must be understood by the Investor so that his assets are in the desired Asset Classes. There are thousands of Funds constantly marketed on TV and Print. One Fund may have the objective of investing in small company stocks.
Another might invest in long term Treasury Bonds. Still another might invest in Gold. Some Funds might invest in a combination of Asset Classes such a Balanced Funds. These funds invest in both stocks and bonds. There are many different fund objectives and combinations of Asset Classes in use by mutual funds and ETFs. The investor must understand the objective of the fund so that the Fund objective matches the objectives of the investor.
Now let's return to the discussion with Dad and the Adult Education Classes. Dad has stated that his money was invested in Stocks, Bonds and Mutual Funds. This would have been a true statement if Dad had been describing how he invested his money, not the Asset classes he in which he was invested.
After he finally agreed to let me review his holding, I discovered that Dad was holding 50% of his assets in medium size individual stocks, 20% in long term individual Bonds, and 30% in Mutual Funds which all held small company stocks. Essentially, the portfolio was undiversified and was too risky given Dad's age.
After several conversations about Asset Classes, Dad finally agreed to reallocate all his holdings into a number of Mutual Funds including a Money Market fund, several large company stock funds, two bond funds, a commodity fund and a real estate fund which diversified his assets and lowered the overall level of risk.
Dad was leery of having all money in Mutual Funds since he still viewed Mutual Funds as an Asset Class. Eventually, Dad began to understand that Funds are only a means of investing in the underlying assets or Asset Classes, and that Funds are not Asset Classes in and of themselves.
Peter Owen - Peter B. Owen, ChFC, CLU, FLMI, CRSP, CISP Peter is President of Trendline Financial Solutions, a family Financial Planning Practice ...
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