Investment is a game of expectations

 Although I have initiated my article with not so creative line, but it may sound interesting to a few investment enthusiasts.

There are basically three investment asset classes, namely, equity, fixed income and alternative assets. Each has its own pros and cons in terms of risk- return trade-off, liquidity, diversification benefit, investment horizon, information availability, inflation hedge, different level sensitivities to different factors like GDP, interest rates, currency fluctuations, business cycle, etc.

It is just a matter of one’s estimates and expectations, which factor will outperform the other in the most likely future conditions or where short term under-valuation and over- valuation can be exploited due to current market inefficiencies on the basis of expectations that markets would realise their true intrinsic values eventually.

For instance, if a fixed income manager expect to see a large parallel downward shift in interest rates, then he would most likely to increase the duration and convexity of his positions, whether by adopting barbel strategy or buying call/ put options on bonds or buying bonds with embedded put options or entering received fixed/ pay floating rate swaps.

Alternatively, if the same fixed income manage expected a large parallel upward shift in yield curve, he would like to have a lower most exposure to duration and convexity to reduce the negative impact on current bond positions. It can be achieved by shorting of bonds or writing call/ put options on bonds or buying callable bonds or mortgage backed securities instead of plain vanilla bond or by entering received floating/ pay fixed swaps.

And just to add another perspective of equity asset class, if an equity portfolio manager estimated overall markets to rise in the future due to improvement in macro-economics variables, he would like to increase his exposure to high beta or small cap and mid cap stocks either by directly owning the assets, or having a synthetic position via. derivatives like equity forward, futures and call options whichever sub-asset class.

Finally, there is last but is an interesting assets class of assets, alternative investments which includes real estate, private equity, commodity, distressed securities, managed futures, etc. with their own idiosyncrasies like high return potential driven by high risk premium related due to lower liquidity, lack of information availability, market inefficiency, longer time horizon, high risk of failure, etc. Hence, a long term risky investment manager may want to capitalise upon the possibility of earning high risk adjusted return with the one or the other sub-group of alternative investments on the basis of his expectations and estimations for out-performance of that asset in a give time- horizon and estimated conditions.

There is one more expectation for future correlation of returns amongst these asset classes which may materialise on the basis of correlation of historical return with given conditions or modelled estimates to provide the benefit of diversification in a portfolio with a appropriate mix of assets from different classes.

Moral of the story: investment is a game where every individual and institutional investor trying to out-perform the market as per their expectations based upon less or more sophisticated forecast of future returns under given conditions.