Asset Classes

Common equity represents an ownership stake in a corporation. Equity holders are residual claimants — they receive what remains after all creditors, bondholders, and preferred shareholders are paid. This residual nature makes equities riskier than debt but also creates the potential for higher long-run returns.

Historically, U.S. large-cap equities (S&P 500) have returned approximately 10% per year nominally, or about 7% in real terms, making them the highest-returning major liquid asset class over long horizons.

Building on the CAPM, empirical research has identified persistent return premia associated with:

• Market (beta): Compensation for systematic, non-diversifiable risk.
• Size (SMB): Small-cap stocks have historically earned a premium over large-caps (Fama-French 1993).
• Value (HML): High book-to-market (value) stocks have earned a premium over growth stocks.
• Momentum (WML): Stocks with strong recent 12-month returns tend to continue outperforming over the next 6–12 months (Jegadeesh and Titman 1993; Carhart 1997).
• Profitability and Investment: More profitable firms and firms investing conservatively earn higher expected returns (Fama-French 2015).

• Domestic vs. International: Developed market international equities provide geographic diversification; correlation with U.S. equities has increased over time but remains below 1.
• Emerging Markets (EM): Higher expected returns but higher volatility, lower liquidity, and greater political/currency risk.
• Sectors: Energy, Technology, Financials, Healthcare, etc. exhibit distinct factor loadings and business cycle sensitivities.
• REITs (Real Estate Investment Trusts): Publicly traded, equity-like instruments backed by real property; discussed further under Real Assets.

A bond is a debt instrument in which the issuer promises to pay the holder specified cash flows (coupon payments and principal repayment) on defined dates. Fixed income is the largest asset class by outstanding value and serves as the primary tool for managing interest rate exposure, liquidity, and portfolio duration.

The price of a bond is the present value of its promised cash flows:

\[P = \sum_{t=1}^{T} \frac{C}{(1+y)^t} + \frac{F}{(1+y)^T}\]

Where \(C\) is the periodic coupon, \(F\) is the face (par) value, \(T\) is maturity, and \(y\) is the yield to maturity (YTM). The YTM is the internal rate of return assuming all cash flows are reinvested at the same rate and the bond is held to maturity.

Modified duration measures a bond's price sensitivity to yield changes:

\[\frac{\Delta P}{P} \approx -D_{mod} \cdot \Delta y\]

Convexity captures the curvature in the price-yield relationship. Because convexity is positive for most bonds, actual price increases exceed the duration approximation when yields fall, and actual price declines are smaller than the duration approximation when yields rise.

The yield curve plots YTM against maturity for bonds of equivalent credit quality (typically U.S. Treasuries). The shape conveys market expectations about future rates and the macroeconomic environment:

• Normal (upward sloping): Long rates exceed short rates; consistent with positive term premium and expectations of rising rates.
• Inverted: Short rates exceed long rates; historically a reliable leading indicator of recession.
• Flat: Small spread between short and long rates; often a transition state.

The term premium — the extra yield demanded for holding long-duration bonds — is time-varying and can be estimated via models such as the ACM (Adrian, Crump, Moench) decomposition.

Cash equivalents are short-term, highly liquid instruments with maturities under three months and negligible credit risk. They serve as the risk-free asset in portfolio construction (or proxy thereof) and provide "dry powder" for deploying into other asset classes at attractive valuations.

• U.S. Treasury Bills: Benchmark risk-free rate; no credit risk, minimal duration
• Money Market Funds: Pooled vehicles investing in T-bills, repos, commercial paper, and agency paper; maintain $1 NAV under standard regulation
• Commercial Paper (CP): Unsecured short-term corporate debt; yields slightly above T-bills
• Repurchase Agreements (Repos): Collateralized short-term lending; critical to dealer financing and monetary policy transmission
• Certificates of Deposit (CDs): Bank-issued time deposits; FDIC-insured up to applicable limits

In mean-variance optimization, the risk-free rate determines the capital market line (CML). Portfolios combining the risk-free asset with the tangency portfolio dominate all risky-asset-only portfolios — this is the two-fund separation theorem. In practice, T-bill yields represent the opportunity cost of holding equity and serve as the risk-free rate in the CAPM:

\[E[R_i] = R_f + \beta_i (E[R_m] - R_f)\]

Real estate encompasses land, residential, commercial, and industrial properties. It provides income (rent), capital appreciation, and inflation hedging, but is highly illiquid and requires substantial capital.

Commodities are physical goods traded in standardized contracts: energy (crude oil, natural gas), metals (gold, silver, copper), and agricultural products (corn, wheat, soybeans).

Infrastructure assets — toll roads, airports, utilities, pipelines — provide essential services with regulated or contracted cash flows. Key characteristics:

• Long asset lives and stable, inflation-linked revenues
• High barriers to entry (natural monopolies)
• Low correlation with public equities over long horizons (though publicly-listed infrastructure is more correlated)
• Accessed via direct investment, unlisted funds, or listed infrastructure ETFs/funds

Hedge funds are privately organized, lightly regulated investment vehicles that employ a broad range of strategies using leverage, derivatives, and short selling. Performance is measured against absolute return benchmarks rather than market indices.

Private equity (PE) invests in companies not publicly listed on exchanges. The two main forms are:

Private credit provides debt financing to companies outside the public bond market. It has grown substantially since 2008 as banks reduced direct lending to middle-market companies. Instruments include:

• Senior secured direct lending: Floating rate, covenant-heavy; 1st lien priority
• Mezzanine debt: Subordinated; higher yield with equity "kickers" (warrants)
• Distressed debt: Purchasing discounted debt of financially stressed companies
• Special situations: Bespoke, complex financings not fitting standard categories

Yields in private credit significantly exceed equivalently-rated public bonds, reflecting the illiquidity premium.

The variance of a two-asset portfolio is:

\[\sigma_p^2 = w_1^2 \sigma_1^2 + w_2^2 \sigma_2^2 + 2 w_1 w_2 \sigma_1 \sigma_2 \rho_{12}\]

Diversification benefits increase as \(\rho_{12}\) decreases. Critically, correlations are not static — they tend to increase sharply in market crises (correlation breakdown), precisely when diversification is most needed.

• Strategic Asset Allocation (SAA): Long-run policy weights reflecting investor risk tolerance, time horizon, and liabilities. Driven by long-run expected returns, volatilities, and correlations (e.g., Black-Litterman framework).
• Tactical Asset Allocation (TAA): Short-run deviations from SAA based on valuation signals, momentum, or macroeconomic forecasts. Evidence for consistent TAA skill is mixed.

Rather than allocating capital equally across asset classes, risk parity allocates risk (volatility contribution) equally. Because bonds have much lower volatility than equities, risk parity portfolios hold more bonds and employ leverage to achieve equity-like returns. The approach is theoretically grounded in the observation that equity-heavy portfolios concentrate risk in a single factor (equity market beta).

Pioneered by David Swensen at Yale, the endowment model (or "Yale model") significantly overweights illiquid alternatives — private equity, venture capital, real assets, and hedge funds — relative to traditional stocks and bonds. The model is predicated on:

1. Compensation for bearing illiquidity
2. Access to manager alpha in less efficient markets
3. Long investment horizons that allow riding out illiquidity

Critics note the model requires truly long horizons, access to top-quartile managers, and tolerance for large drawdowns, conditions not met by most investors.

Maximum drawdown is the largest peak-to-trough decline over a period. Value at Risk (VaR) estimates the loss threshold not exceeded with probability \((1 - \alpha)\). Conditional VaR (CVaR / Expected Shortfall) averages losses in the tail beyond VaR and is a coherent risk measure preferred by regulators and sophisticated practitioners.

The assumption of normally distributed returns understates tail risk for most asset classes. Fat tails, skewness, and time-varying volatility (GARCH effects) are empirically documented across equities, fixed income, and alternatives.

Liquidity risk is the risk that a position cannot be closed without significant price impact. It is particularly relevant for:

• Small-cap and micro-cap equities
• High-yield and distressed bonds
• Private equity and venture capital
• Real estate
• Certain hedge fund strategies

The bid-ask spread and Amihud illiquidity ratio (|return| / dollar volume) are common measures of market liquidity. Liquidity dried up severely during the 2008 financial crisis and COVID-19 shock, demonstrating that liquidity risk is correlated with other risk factors.