Asset allocation is arguably the most important decision faced by investors, yet there are no accepted criteria to qualify investments as asset classes. Consequently, some investments take on the status of an asset class simply because the managers of these assets promote them as an asset class. They believe that investors will be more inclined to allocate funds to their products if they are viewed as an asset class rather than merely as an investment strategy. Alternatively, the investment industry often overlooks investment categories that legitimately qualify as an asset class because investors are reluctant to defy tradition.This imprecision about the nature of an asset class reduces the efficiency of the asset allocation process in at least two ways. First, if disparate investments are inappropriately grouped together into an asset class, the portfolio will not be diversified efficiently. Second, if an asset class is inappropriately partitioned into redundant components, the investor will be required to deploy resources unproductively to analyze irrelevant expected returns, standard deviations, and correlations. Moreover, the investor may waste additional resources in search of irrelevant investment managers. It should, therefore, be of some value to establish criteria for the purpose of identifying legitimate asset classes.The list of proposed asset classes is long and diverse. The traditional candidates are:
Domestic Stocks Domestic Bonds
Foreign Stocks Foreign Bonds
Real Estate Cash Equivalents
The stock and bond categories are often subdivided into more specific groups, such as:
Large cap stocks, mid cap Stocks, small cap Stocks, growth stocks, value stocks, financial stocks, developed market foreign stocks, emerging market foreign stocks, long-term government bonds, long-term corporate bonds, intermediate-term government bonds, intermediate-term corporate Bonds, high-yield bonds, municipal bonds, developed market foreign bonds, emerging market foreign bonds.
Finally, there are the so-called alternative investments, which include among others:
Commodities, market neutral funds, currencies, private equity, hedge funds, timberland, managed futures, and venture capital.
Criteria for Asset Class Status I propose four criteria for determining asset class status, to wit:
1.An asset class should be relatively independent of other asset classes in the investor’s portfolio.
2.An asset class should be expected to raise the utility of the investor’s portfolio without selection skill on the part of the investor.
3.An asset class should be comprised of homogeneous investments.
4.An asset class should have the capitalization capacity to absorb a meaningful fraction of the investor’s portfolio.