How would you answer the question, “What is an asset class?”

This sounds like a simple question, but it turns out that even large institutions struggle to provide a well-defined answer.

In this post, we’ll discuss why it matters and how to define an “asset class.”

The Tangency Portfolio and the Risky Asset

In a previous post, we observed that if the goal is to preserve, protect and build wealth for future generations or purposes, historically it has been a mistake to concentrate the portfolio in the “riskless” asset.

Nevertheless, there is a good argument that some portion of the portfolio should be in a low risk or “riskless” asset and the remainder in a “risky” portfolio.

If an investor is going to adopt the idea of holding some assets in a very low risk asset, such as T-Bills, and the remainder, which may vary over time, in a risky asset, that returns us to the question of what that risky asset should be.

That risky asset should almost certainly be a portfolio of assets.

Market Efficiency

Modern Portfolio Theory is founded on the idea that markets are efficient in the sense that it is very difficult (or impossible) to consistently outperform “the market” on a risk-adjusted basis.

An investor who is going to adopt a “barbell” strategy as outlined previously, and is not going to attempt to select stocks to beat the market still faces several important decisions in selecting a “risky” portfolio.

The Risky Portfolio

Let’s posit that the risky portfolio should, as the mean-variance approach suggests, have no more risk than necessary for the chosen level of expected return. And let’s begin with the assumption that markets are pretty efficient.

We might then ask the following questions:

1. What assets/asset classes comprise the market?
2. How much diversification is “enough”
3. What should be the default weightings for each holding?
4. Are there hidden risks, e.g. from lack of transparency, political, legal
5. Are there any systematic anomalies (e.g. the value anomaly) that we want to consider?

We will look at each of these in turn.

Assets/Asset Classes

You can’t go far in the discussion of risky portfolios without running into the issue of asset classes.

For many people, the two traditional asset classes are stocks and bonds. These are also sometimes referred to as equities and fixed income. For most purposes these two sets of terms are interchangeable.

No Agreed Definition

Among academics and practitioners, there is no universally agreed-upon definition of an asset class.

Let’s back up and think about why any investor (as opposed, for example, to people selling investments or investment management services) might care about asset classes.

Why Care About Asset Classes?

Inherently, most investors do not care about asset classes. They care about expected returns, and risk.

The underlying assumption implicit in the concept of “asset class” is that the assets that constitute the asset class all share “similar” degrees of expected return, and risk, and, crucially, covariance or correlation.

Industry Definition of Asset Class – AWOL?

I find it interesting that while the term “asset class” is thrown around all over the place in the field of investing, the term is rarely defined in a useful manner.

For example, Schwab[1] publishes a 27 page guide the lists and discusses a number of claimed asset classes, without ever defining what an asset class is, or explaining why they selected the classes they did.

Tucked away on rarely visited webpage[2] that you’d probably only ever find if you were specifically looking for it, Fidelity offers a general definition:

 “A group of securities or investments that have similar characteristics and behave similarly in the marketplace. The three primary asset classes are stocks (equities), bonds, and short-term investments.”

Vanguard seems not to offer a definition, though they state[3] in a section titled “Understand the asset classes” that “Each asset class responds differently to market movement.” 

UBS, in a glossary on its website, offers:

“A collective term for investments of a similar type with a unique combination of investment characteristics. The main asset classes are equities (shares), bonds, cash and real estate.”[4]

I found a similar dearth of useful definitions from other large firms. JP Morgan, for example, helpfully explains “Securities with similar features” in its glossary.[5] Blackrock offered similarly vague ideas.

CFA Institute

The CFA Institute trains most of the financial analysts in the world. Its three-year program trains candidates to become Chartered Financial Analysts. The curriculum devotes a significant number of study hours to the concepts of asset allocation and asset class.

Despite this, here is the best definition[6] I could find from the CFA Institute:

“An asset class is a group of assets with similar exposure to the fundamental drivers of the economy.”

Academic Definitions

We can turn to finance academicians for a more technical, and hopefully useable, definition.

Pretty much everyone agrees that what makes an asset class an asset class is that the assets in that class tend to behave similarly to each other, and differently from assets in other asset classes.

In theory, this insight can be operationalized using concepts from statistics. Modern Portfolio Theory, and mean-variance optimization theory in particular, give us a basis for identifying which statistical parameters to look at.

There are several approaches that could be taken, including clustering (e.g. K-means), principal components, factor analysis and linear regression.

A Working Definition

Given these considerations, we can define an asset class as a set of assets that have similar expected returns, risks, and that have a share a high degree of covariance (i.e. the returns of which are highly correlated.)

Practical Issues

This definition immediately presents the practical issue of determining the expected returns, risks, and correlations, in advance.

The future performance of any asset is, by definition, unknown. We can estimate it, guess at it, model it, or read tea leaves, but we cannot know ex ante.

Thus, it becomes necessary to look at characteristics that we believe are stable or predictable, and which are likely to influence the returns to assets.

That will be the topic of a future post.

Next steps

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[1] SCFR Guide to Asset Classes 2023 by the Schwab Center for Financial Research

[2] https://www.fidelity.com/research/funds/glossary-workplace.shtml

[3] https://investor.vanguard.com/investor-resources-education/article/choosing-the-right-asset-mix?utm

[4] https://www.ubs.com/us/en/assetmanagement/funds/glossary.html?utm

[5] https://am.jpmorgan.com/us/en/asset-management/adv/resources/glossary-of-investment-terms/

[6] And this is unofficial – from a blog: https://blogs.cfainstitute.org/investor/2019/12/30/what-is-an-asset-class/?utm