ASSET CLASS SUMMARIES & COMMENTS:

Major Asset Classes:

Asset Classes are a critical component of the overall Asset Allocation structure in portfolio construction, and it is critically important to utilize appropriate asset classes to achieve a reasonable risk/return balance.  This section covers the major asset classes from a broad-based level, and then provides more detail for specific asset classes.  At a very high level, there are:  a) Equities,  b) Fixed Income, and c) Alternatives.  Cornerstone primarily utilizes existing Morningstar asset class categories.  Morningstar provides a comprehensive investment source that includes extensive asset class data.  Morningstar is a highly-credible service that is not trying to sell anything other than higher-level research packages.  It is noteworthy that the free site contains a wealth of information.  See:  Morningstar

 

Equities:

Equities generally comprise public ownership of corporations through common and preferred shares.  Public ownership means that anyone can purchase shares in a publicly traded corporation and they then become a partial (albeit a relatively small) owner.  Equity asset classes are divided into domestic US corporations (which may do business in both this country and abroad) and foreign corporations.  Foreign corporations are further broken down into developed countries (like the UK and Germany) and emerging countries (like China and Mexico).

Domestic asset classes are disaggregated into more discrete asset classes that include Large Capitalization, Mid Capitalization and Small Capitalization corporations.  These three size categories are further divided into Growth, Blend/Core, and Value.  The result is nine asset classes that represents the size and style holdings for domestic US corporations.  A good way to visualize these nine asset classes is to look at the largest broad market ETF-The Vanguard Total Stock Market Index-VTI.  See:  Total Market Style Boxes  The Morningstar site shows the holdings percentages for each of the nine style boxes.  The Vanguard Total Stock Market Index ETF is nicely diversified with heavier weights in the larger asset classes and smaller weights in the small caps.  There is also a reasonable balance between the Growth Investment Style and the Value Investment Style.

Foreign equity asset classes include domestic and emerging markets, and they also fit the Morningstar size and style boxes.  The Vanguard Total International Stock ETF shows broad foreign asset classes.  See: Foreign Size and Style Asset Classes  This fund shows a smaller percentage of smaller capitalization companies and a modest Value overweight which is typical for foreign corporations.

Equity sectors and regions are also legitimate asset classes.  A portfolio could attempt to earn a higher return by adding a bio-tech sector fund like the iShares Nasdaq Biotechnology-IBB ETF.  The iShares China Large Cap-FXI is an example of a regional holding.

Fundamental and Factor Funds:  Fundamental and Factor styles have merit as well.  See Cornerstone Models.

Private Equity:

Private Equity – PE involves investments in companies that are not available to the “public” market stock exchanges.  Although there are many companies from small to large that are not publicly held and traded, the term Private Equity usually refers to large companies owned by institutional and well-healed retail investors.  A typical PE fund purchases existing companies that are underperforming and are in need of a major restructuring.  These underperforming companies are purchased using a small portion of equity and a large amount of debt.  The PE firm usually replaces management and does extensive cost cutting and business line rationalization.  Presumably these changes will cause a turnaround that accelerates profitability and cash flow generation.  When the private company is performing strongly, then the PE firm takes the company public by selling shares in the stock market.  Funds from the stock sale are then used to repay debt and purchase other underperforming assets, and the cycle repeats.  In other cases, some companies typically do not need to raise public equity capital and consequently they remain as private entities.  Cargill and Koch are examples of large private companies.  Although private equity is relatively illiquid, numerous studies have shown that Private Equity investing generates returns that are superior to public stock market returns.

Since the minimum size to invest in Private Equity is very high, it is an investment that is not readily available to most investors.  However, since pension funds, insurance companies and other institutional investors purchase PE, it is possible that the individual investor has PE exposure through these various institutional holdings.  Ironically, many PE companies have gone public by selling a part of their business to individual shareholders.  Theoretically, these public shares in private companies provide an opportunity for small investors to invest in PE.  Examples include: Blackstone-BX, Carlyle Group-CG, KKR Co.-KKR and PowerShares Global Listed Private Equity Portfolio-PSP.  Investment performance ranges widely for these public entities and it is difficult to generalize about overall investment performance.

 

Venture Capital:  Venture Capital-VC is another form of private equity that is mostly available for the largest investors.  Venture capital involves providing capital to new start-ups that have innovative products for new markets with explosive growth potential.  Well known examples from past venture capital success stories include Apple, Federal Express, Google, Intel, Staples and Yahoo.  Technology, health care and clean energy are typical industries that benefit from VC funding.  Although there are many exciting success stories, the reality is that most VC funding goes to companies that fail.  As a result, VC investments need to be diversified in a number of companies with the recognition that a few big winners must offset the vast majority of losers.  VC funding is illiquid and the timeline is very long.  VC funding goes through stages that starts with seed capital from friends and family.  This seed capital stage is sometimes called angel investing.  The next stage is called early-stage and it is the point where institutional VC investors get involved.  As the company gains viability additional VC investors provide capital for expansion and commercial operation.  If the company evolves to this stage, then it may be bought by an existing company that is seeking to expand into this new market.  Another option is for the company to go public through an Initial Public Offering-IPO where shares are sold to equity investors and the shares begin trading on public listed stock exchanges.  The IPO process allows VC investors to be paid off (at huge gains) from the funds that are raised from the shares that are sold to the public.  Angel investors are another early-stage private funding source.  Twin Cities Angels is an example in Minneapolis, MN.

It should be noted the VC funding is really a form of private equity, but it is far different from the typical PE investments.  First, traditional PE firms make large investments usually well over $100 million in existing companies.  Meanwhile VC investments go to high risk/high return startups and the typical investment is under $10 million in a company.  In addition, venture capital returns are much more volatile than traditional private equity.  Due to the higher risk level, VC investments use equity and no debt.  There is no easy way to measure investor returns, but large, successful VC funds typically earn higher returns than equity investors in the publicly-traded stock market.  It is difficult for most retail investors to directly participate in the VC market, but many mutual funds include some VC holdings.