Asset Classification

Asset Classification thumbnail

The financial market is a place where buyers and sellers engage in the trade of assets. Generally speaking, we define assets as real, financial, or intangible. Each of these asset types has category-specific characteristics.

Real Assets

Real assets are physical and include precious metals, commodities, real estate, land, and so on. These assets are normally held by operating companies, such as real estate developers, aircraft manufacturers, and loggers. Nowadays, investment managers include real assets in their portfolios because of their low correlation with traditional financial securities, for instance, stocks and bonds.

When it comes to acquiring real assets, we can choose between direct investment (physically acquiring them) or indirect investment (buying shares of companies that invest in such securities). Suppose that you want to get exposure to gold. You could physically buy and store it somewhere — in the bank, in the home vault room, or even under the mattress — or you could just buy the stock of a company that develops gold mines. As such, direct investment in real assets requires substantial management costs and expertise. Therefore, investors need to conduct ample due diligence before gaining direct exposure to real assets.

One way to get around the costs associated with direct investing is to buy the so-called REITs. REITs stands for real estate investment trusts. Most REITs are publicly traded like stocks, making them highly liquid, which is not a common feature of most direct real estate investments. A REIT works just like a mutual fund, allowing both large and small investors to own a share of the managed trust.

Intangible Assets

Intangible assets are not physical in nature. They include patents, trademarks, and intellectual property, which have a tremendous perceivable value. The copyright to a song is owned by the record company that produced it. If you wish to use the song in some form, you are required to pay a royalty. You can’t see or touch the royalty, but it’s there. The brand recognition of an organization is another example of that.  

Typically, intangible assets are divided into two sub-types — definite and indefinite. Definite intangible assets refer to various patents, databases, and intellectual property that a firm buys access to for a limited period of time. Other examples of intangible assets with a finite life are software licenses, concessions, and even sports contracts. By contrast, the useful lives of indefinite intangible assets continue for as long as a firm remains in business. These mostly include trademarks, goodwill, a company’s brand recognition, and even its website. This is an extremely important aspect to consider when it comes to Mergers and Acquisitions.

In practice, firms may create as well as acquire such assets. Either way, it is difficult to value, account for, and invest in what’s invisible to the eye. While you cannot physically buy a piece of Apple’s brand recognition, you can still perceive it as a driving force for generating sales, which will later have an impact on Apple’s share price. In other words, intangible assets add value to both investors and organizations and may be as integral as tangible ones. Keep in mind that the expenses related to creating and acquiring intangibles must be recorded in the Balance Sheet of an organization.

Financial Assets

Financial assets stand somewhere in between the other two and derive their value from a contractual claim of an underlying asset that can be either real or intangible. For example, precious metals such as gold and silver are real assets. However, “precious metal futures” is considered a financial asset because the contract’s rate is driven by variations in the underlying asset price. In fact, financial assets themselves have sub-categories, too. These include:

  • Securities
  • Derivative contracts
  • Currencies

Securities can be further broken down into fixed income (also known as debt), equity, and pooled investment vehicles, such as mutual funds and hedge funds. Debt securities are promises to repay borrowed money. Equity represents ownership in a company. And a pooled investment vehicle refers to the combination of funds in an investment portfolio. Another way to look at financial securities is to specify whether they are public or private. Public securities trade in public markets such as exchanges and are subject to regulatory oversight. All other securities are private.

A “derivative”, on the other hand, is a financial instrument whose price is determined by one or more underlying assets, like stocks, bonds, interest rates, commodities, and exchange rates. We can differentiate between financial and physical derivatives depending on whether the underlying instruments are physical products or financial securities. Financial derivatives are based on equity and debt, whereas physical ones are built on real assets such as gold, oil, and corn.

Currencies represent money issued by national monetary authorities and represent a medium of exchange. U.S. dollars, euros, Japanese yen, and pounds are all examples of currencies. They are recognized as stores of value and are traded between nations in foreign exchange markets.

The Bottom Line

If we compare real with financial assets, we will see that financial assets are better in that they offer better liquidity, convenience, and efficiency. Those also have a readily realizable monetary value. Alternatively, real assets are perceived to be a safer choice with respect to inflation and economic downturns. So, which one, and how much of each should you include in your investment portfolio? Before making such a decision, a financer must study financial assets in more detail.

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