I’ve just thought out a pretty cool idea – however not a new concept – to construct a qualitative, active update-able, and relatively personal perspective (i.e. very subjective) matrix between asset classes and risk perspectives. There is some perspectives that is pretty interesting about the correlation between (1) events and assets’ prices, and (2) between price behaviors of different asset classes. Let’s call them Risk Appetite – a desire for risk – of different asset classes.
Some asset classes have a strong risk characteristic, either way of risk seeking (e.g. high-yield bonds) or risk avoiding (e.g. Swiss Franc, Japanese Yen). Some asset classes have a changing, or mixed risk personality – like gold. And there is always movements in asset classes risk appetite between different time periods (gold was considered “normal” good from 1980-2000 and changed to “value keeping asset” from 2000 to now), time horizon (U.S. stock average has 4% higher return per year than bond counted from 1900, i.e. they are safe & defensive – however traditionally stocks are consider risky asset – mostly because no-one invests for that 100 years long), or whatever else can make people change their mind about riskiness of a particular asset, it can be ethic, political factors, natural factors, technological factors, or even innovations from the financial sector. Think about Credit Default Swap (“CDS”), CDS was thought out to prevent default risk – so basically it hedges the downside risk of an asset. It’s an “insurance” for whatever you want to buy. Does it reduce risk? Think about the last financial crisis – It reduced one kind of risk but increased another: moral hazard.
Thinking about all of this makes me excited.
So yea, what I’m doing now is classifying different types of asset: this guy is good, this guy is bad, this guy is risky, this guy is safe … cool? Ok now cool down, and remember some big BUT(s) here – egh, this is important – read it very carefully.
1/ This is my personal point of view – from my taste, experience and knowledge. It doesn’t come from a thoroughly academia (that I think would take years, and when it finishes, those characteristics already change). So it will be highly subjective hence not necessarily right, if not to say some items will be deadly wrong. Disclaimer: don’t base your investment into this – I won’t take responsibility.
2/ This is very qualitative and I’m fully aware all of the short-falls of it. Think critically you’ll kill the idea right away: when I type “Liquidity: Very High” – how much is “very high?” I don’t know the figures – but I know the market’s characteristic: its width, depth, large blocs doesn’t change prices or bid-ask spread – that would be “very high”. Don’t ask me about vertical comparison or horizontal comparison for an absolute scale in any characteristic – that would require a full study with full access into data which I don’t have access to both Bloomberg Terminal or Reuters (and I don’t know whether they have it). Moreover, what I even want to focus more is the personal perspective on that market. It’s the psychological and emotional part of traders that define width and depth of a market. So if they all, the traders, consider the market is “very liquidity” – so the market is “very liquidity”, right? who cares the number? Number may change and the traders may be wrong – like the case in 2008, even with CDS, when they thought they had enough liquidity but finally turned out that liquidity dried even faster than a blink and they couldn’t liquidate their positions. So market changes, perspective remains – that’s the idea.
3/ This is not ultimate version – and there will be no ultimate version – because the markets always change and people’s reference changes. What I want to do is to update the table continuously – time by time, so we’ll see how things change and be adaptive to it. I would be extremely appreciate if anyone involves into this long journey – discuss, figure out, analyze, add in, extract out, and share ideas about all of the factors in the matrix. I’ll keep a list of changes at the end of the note so we can track all of our movements.
4/ Finally, remember that this is a highly debatable and controversial issue – based on my reference, it would be “this” but based on your reference it would be “that”. It’s just simple as two people look at the same thing and see it different. But let’s build it – it would be nice to hear all voices and share all thought. I believe we will be all better off and learn something from the process itself.
That’s it – here the table:
- Asset Class – The asset classes are listed in term of liquidity, with the first 3 belongs to big 3: Cash, Stock, Bond. Then followed by commodities and other alternative investments. This list is not either exhaustive as well as geographic focus. Because if we divided the world into advanced countries, emerging countries, frontiers countries, and others – we would easily assert the differences of risk (in a very general way): Most risky belongs to frontiers, and lessens followed by emerging and advanced. Geographic risks assessment is an interesting topic for further thinking I think – It would be highly applicable in forex investing.
- Liquidity – measure how well in term of price movements and time for selling off any asset to cash. A market is liquid when it’s fast to sell off large blocs without any significant change in price. Most liquid market belongs to foreign exchange – with US$4 trillion daily trading value (according to Bank of International Settlements) – Forex trading involves millions of players from retail investors to largest financial institutions and operates globally 24h a day, 5 days a week. To the least liquid is Private Equity and Collectibles – Private Equity investing normally requires investor to commit 10 years of capital. Hedge Fund investing can be very short-term comparing with Private Equity, because most Hedge Funds are open-ended, therefore investors can redeem at the end of each investment period (quarterly or yearly).
- Risk Appetite – gauge the feeling of investors toward asset classes. CHF & JPY are consider safe heaven due to their stable economy and large bond market backed. Note that currency goes very closely with debt market. When people fear and run away from stock market, and let say people turn into safe haven: JPY – then they will buy Japan’s government bond after converting their currency into JPY. The same with USD. USD is a relatively neutral currency because USD is used for global transactions. Commodities are also priced mostly in USD. However, USD is consider safe haven because when people panic, they turn into USD and then buy US Treasury Bonds. Oil & agriculture are relatively neutral I think. Oil prices depend on industrial supply, demand, and expectations. However one interesting characteristic of oil is that oil prices also tend to go reverse with US Treasury Yield – this is not a dominant factor in oil price, however should be considered. This is because oil exporting countries have the tendency to sell more oil when yield increases (and take the cash from selling oil to invest around, mostly US Treasury). Hedge Fund are considered risky business. Because they are not regulated, and only the “accredited” investors can invest (like high educational persons or the rich – net worth more than US$5M for example, I don’t remember the exactly the number). Private Equity also requires large investment and long time horizon. There is many perspectives consider Hedge Fund to be a not risky business. Because Hedge Funds are created to “hedge” out all the risk and bring fair return regardless of market direction. This depends a lot of type, and strategies employed by the fund – hence, very controversial.
- Risk Perspective – Go further from Risk Appetite, some asset classes are risky, but how different are those “risky”? This part answers that question. ETF (Exchange Trade Fund) can almost be constructed in any kind of asset, just like derivatives. Therefore risk of ETF can be very vary, depends on the kind of asset it constructs in. Frontier markets are market which is extremely infancy, like Vietnam, Algeria, Cambodia, … Investing into frontier markets are quite interesting, because they mostly don’t correlate much to the world, so one study shows that a well diversified frontier markets portfolio can hedge out all of the market risk. However they are considered a very aggressive investing, because frontier markets contain itself some highly risky characteristics: political corruption, administrative barrier, infrastructure, long-term horizon… I consider gold to be a fairly risky asset – because the volatility of gold. Of course you can increase time horizon and smooth out market risk – however you also take in uncertainty.
- Time Horizon – This is another highly debatable point because time horizon depends on investment reference, and therefore, this point might be very different among different players. I take currency as “short” because they are highly correlated to movements of any kind: news, other prices, economy, political, … as well as “long” because they also associated closely with bond market. US Treasury as “short” because they also highly correlated with other movements. There is 30 yr notes, however, they are highly liquid and can be sold off any time the market (mostly stocks) is better and buy back any time the market is worse. Mostly US Treasury are active considered as “cash equivalent” – hence very short-term.
- Sensitivity – Measure the sensitivity or correlation of prices regarding to other news and prices. USD is relatively sensitive because everything related to it. CHF, JPY go their own way for the last 10 years: stronger as people stay away from USD. Private Equity almost hedges out all the market risk as they play on a very long-term time frame, however, entry & exit point of Private Equity – on the other hand, highly depends on the market. Hedge Fund mostly invests in liquid markets and therefore sensitive to market risk. Moreover, Hedge Funds employ very different strategies, there are some funds actively try to hedge out the volatility like long-short strategy fund. However others expose to it and exposes highly to it like macro driven funds, short-bias, long-bias, or M&A fund. Collectibles like antiques is almost perfect for value storing: long-term, low market risk, no foreign or political or country risk exposure. The problem with them: don’t sell them in fire.
So why do I construct this table? well, in a long run, price of assets are like tides, wave after wave, and the momentum will run unless there is something to stop, mark a change, start a new trend. There is always some basic things we can’t change: prices go up, go down, and go nowhere. Risk avoiding assets prices go up with the world’s panicking – like JPY, US Treasury, CHF, Gold. Risk seeking assets prices go up with the world’s optimism – stocks, PE, Junk-Bonds. There’s just a massacre in global stock markets yesterday and today. Where do you think people will put their money in?
Portland, Oregon – September 22nd, 2011