An asset class is a category of investments that share similar characteristics and are governed by the same rules and regulations. It must be noted that within an asset class, the individual investments perform in a comparable manner in the financial markets. For example, stocks (equities), bonds (fixed income), commodities (like gold and oil), and real estate are all different asset classes. Each of these groups has its own characteristics and behaves in distinct ways.
Investors must understand these asset classes to smartly diversify their portfolios. Also, such an understanding helps in managing risks, as different asset classes often respond differently to economic changes. Let’s understand the different types of mutual funds based on asset classes in detail and learn what are alternative asset classes. We will also study the various additional factors primarily used for classifying assets.
What is an asset class?
Asset classes are categories of financial instruments with shared characteristics and correlated market performance. Common asset classes include:
- Equities: Investments in ownership shares of companies.
- Fixed-income securities: Debt instruments, such as bonds, that promise to pay a specific return over a set period.
- Real estate: Investments in property, including land, buildings, and other physical assets.
- Commodities: Tangible assets, such as gold, oil, and agricultural products, traded in specialized markets.
- Cash and cash equivalents: Highly liquid assets that can be easily converted into cash, such as short-term government bonds.
An asset class represents a grouping of financial instruments that share similar characteristics and are subject to the same regulatory framework. Common asset classes include equities, fixed income securities, cash and cash equivalents, real estate, commodities, and currencies.
It is worth mentioning that each asset class has a unique risk-return profile. This means they offer different levels of risk and potential returns. Also, this diversity allows investors to spread their investments across various asset classes to balance and manage overall risk. For example, stocks may offer high returns but come with higher risk, while bonds might offer more stable returns with lower risk.
By allocating their investments among different asset classes using the strategy of asset allocation, investors can:
- Better achieve their financial goals
- Match their risk tolerance, and
- Enhance the performance of their portfolios
Such diversification protects against significant losses if one asset class performs poorly, as other asset classes might perform better under the same market conditions.
Types of asset classes
Asset classes are groups of investments with similar traits and behaviours. It must be noted that they can be classified using several criteria. For example, consumption assets like oil or investment assets can be categorised based on purpose. Similarly, they can be categorised on the basis of location (domestic or international) and market type (emerging or developed).
For more clarity and to make better classifications, let’s check out the various types of asset classes:
Fixed income
Fixed-income investments, such as fixed deposits and public provident funds (PPF), are highly trusted and popular in India. These investments assure capital protection and offer guaranteed returns. They are considered safe, with minimal to no risk of losing your initial investment.
Fixed income schemes mostly offer steady returns of around 7%-8%. However, these returns may not keep up with inflation. This means they provide security but do not significantly grow your wealth over time. Also, depending on the investment period, these returns are subject to short-term or long-term capital gains tax.
Equity
Equity investments involve buying shares of a company that gives you partial ownership. This asset class has become more popular recently. The main advantage is the potential for high returns as businesses grow and increase in value. However, there is also a higher level of risk due to market fluctuations that can affect share prices.
Among equity options, the Equity Linked Savings Scheme (ELSS) stands out for its tax benefits under Section 80C and a relatively short lock-in period of three years. Also, it is worth mentioning that historically, equities have provided returns of 16%-18%, often outpacing inflation. For successful equity investment, especially in the long term, you must choose a reputable Asset Management Company (AMC) with a strong track record.
Real estate
Some common examples of real estate investments include plots, apartments, commercial buildings, industrial areas, and villas. In recent years, interest in real estate has grown substantially, especially due to the launch of Pradhan Mantri Awas Yojana (PMAY), which aims to provide housing for all. This scheme extends beyond urban areas to semi-urban and rural regions.
However, the real estate market can be unpredictable, especially due to factors like:
- City planning
- Socio-political issues, and
- Project development
Moreover, unlike other asset classes, real estate is not always well-structured or closely monitored. This makes it riskier and more variable in terms of returns.
Commodities
Commodities are tradable goods like gold, silver, bronze, food crops, and petroleum. Their market prices fluctuate based on demand. Also, each type of commodity behaves differently in the market. For example, the price of gold might rise when economic conditions are uncertain, while food crop prices can be influenced by weather conditions.
Commodities are generally not intended for long-term investments, except for some like gold and silver, which can retain value over time. The basic strategy for commodities is to buy when prices are low and sell when they rise. This approach allows investors to potentially profit from the price changes in these physical goods.
Cash and cash equivalents
Cash and cash equivalents, also called money market instruments, include currency, savings accounts, and other liquid investments. These provide the highest level of transactional freedom, as they can be easily accessed and used without restrictions. Many people prefer keeping money in savings accounts or in cash because they lack confidence in other investment schemes or want immediate access to their funds.
However, cash and equivalents usually offer low returns. These returns do not exceed 4% and mostly are unable to keep up with inflation. Additionally, some people hoard cash to avoid taxes, as it is difficult to trace and monitor.
Derivatives
For those unaware, a derivative is a type of financial contract. Its value is derived from the performance of an underlying asset, such as stocks, bonds, currencies, commodities, market indices, or interest rates. On its own, a derivative has no inherent value. Its price depends on changes in the value of the underlying asset.
The derivatives agreements are mostly held between two or more parties and specify certain obligations based on the contract terms. For example, a derivative might allow one party to buy or sell an asset at a future date for a predetermined price. These instruments are often used for hedging risks or speculative purposes.
Alternative investments
Alternative investments are a category of assets that don’t fit into traditional categories like stocks, bonds, or cash. These investments are often more complex and less regulated. They are mostly pursued by institutional investors or wealthy individuals.
Such investments offer high returns, but they come with higher risks. Also, they are often not easily converted into cash, which makes them illiquid. Some common examples of alternative investments include
- Hedge funds, which pool capital to invest in various assets
- Bitcoins and other cryptocurrencies
- Valuable artworks
- Structured products, which are customised financial instruments
Alternative investments can certainly yield significant profits, but their complexity and risk make them unsuitable for all investors.
Types of mutual funds based on asset class
Mutual funds can be classified based on the asset class they invest in. Here are some of the most common types of mutual funds based on asset class:
- Equity funds: These funds invest primarily in stocks . They invest the money pooled in from various investors from diverse backgrounds into shares/ stocks of different companies. The gains and losses associated with these funds depend solely on how the invested shares perform (price-hikes or price-drops) in the stock market. Equity funds aims to generate significant returns over a period but also carry higher risks.Explore more about, What are equity funds.
- Debt funds: These funds invest primarily in fixed-income securities such as bonds, securities, and treasury bills. They invest in various fixed income instruments such as fixed maturity plans, gilt funds, liquid funds, short-term plans, long-term bonds, and monthly income plans, among others. Since the investments come with a fixed interest rate and maturity date, debt funds can be a great option for passive investors looking for regular income (interest and capital appreciation) with medium risks.Read more about, What is a debt fund.
- Money market funds: These funds are a type of debt mutual funds, in these the money markets or capital markets by issuing money market securities like bonds, T-bills, dated securities, and certificates of deposits. The fund manager invests your money and disburses regular dividends in return. Opting for a short-term plan (not more than 13 months) can lower the risk of investment considerably on such funds.Read more about, What are money market mutual funds.
- Hybrid funds: As the name suggests, hybrid funds (balanced funds) are an optimum mix of bonds and stocks, thereby bridging the gap between equity funds and debt funds.
