Asset Classes

It occurred to me, for reasons I'll mention shortly, that we haven't specifically discussed the concept of an 'asset class'. There is a universe of assets out there: you can buy stocks, bonds or real estate for example. Some assets trade on exchanges with daily liquidity and pricing while some assets, like direct investments in real estate, have little liquidity and vague estimates of the current value. There are currencies and gold, commodities and collectibles (e.g. art, wine) amongst others.

Those of us who study the returns and risks of such assets noticed long ago that not all assets go up or down at the same time. That is, they have difference causes of profitability and varying amounts of risk. For example, rising interest rates can be detrimental to bond returns, but may indicate a highly profitable environment for companies and their stocks. Some assets experience high volatility- their price fluctuates dramatically over short periods of time, while others exhibit much more steady returns. Because many individual assets may exhibit similar characteristics, we can group them together into an "asset class". That is, a class of assets is "a grouping of securities with similar characteristics and properties. As a group, these securities will tend to react in a specific way to economic factors" (Ibbotson, SBBI, 2003). Investorpedia adds "and are subject to the same laws and regulations."

This concept was taken a step further in the '50s by looking at the correlation of returns between asset classes. It was reasoned that if a portfolio consisted of various asset classes which were largely uncorrelated, then some parts of the portfolio should zig, while others zag, resulting in a smoother performance of the overall portfolio. Modern asset allocation principles (and efficient market theory) were born.

The definition of an "asset class" is not universal, however. It is generally agreed that stocks, bonds, real estate and cash/cash equivalents are distinct asset classes. What about commodities? It is also very easy to group together stocks by certain characteristics like the size of the company. Small capitalization stocks (small companies) tend to behave very similarly and show distinct risk/reward patters from large cap stocks. Are small cap stocks an asset class or a sub-class? (it is generally agreed that it is a sub-class).

Another definition of asset class is a little broader, including "how returns are created" (yourdictionary.com and others). Are returns created by the manager of a fund or by the act of investing in certain types of investments? More specifically, is a mutual fund an asset class because "returns are created" by pooling money with other investors and hiring a professional manager (a mutual fund)? If so, then there is no difference between a bond fund and stock fund- both would be part of the "mutual fund" asset class, despite the secure knowledge they are very, very different in risk/reward profiles. No need to fret about this, it is also widely agreed that mutual funds are investment vehicles and not a distinct asset class. How can they be, they are merely pools of other assets?

All of this brings me to what prompted this post. In a Barron's article about the troubles of the hedge fund industry, a hedge fund industry exec called hedge funds an asset class. This is rather common- hedge funds like to present themselves as distinctly different from other investments (and they are). But like a mutual fund, hedge funds are a particular investment vehicle with a particular strategy, only more dependent on the skill of the manager. Mutual funds' returns are highly correlated with the asset class they invest in (there was just one stock fund up last year). Hedge funds invest in mostly the same underylying asset classes as mutual funds (often with more sophistication, using shorting and derivatives liberally) but rely on the manager's skill to have returns uncorrelated with those general asset classes.

This misleading classification of hedge funds as an asset class is forgivable in my opinion. While hedge funds are a sub-class or style, and certainly not an asset class, you never hear "sub-class" in investment parlance. "Class" and "sub-class" are interchangeable the same as if I were to say "let's take my car" knowing it is an an SUV or pickup truck. But to the unitiated, this terminology may sound like the investor is lucky to be able to invest in a new asset class when really they are investing in a style or strategy of investing wholly dependent on the manager's skill. A particular strategy is not the same as an asset class.