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Not All Assets Are Classes: Why It Matters


To create true diversification in a portfolio, look closely at the underlying assets of a new investment -- just don't wait until it's too late.

Back when there were only a few asset classes, before the tidal wave of financial innovation, portfolio building was a lot simpler. Investors had to contend with three main asset classes: cash, bonds, and equities. Most investors could rely on a 60/40 portfolio of stocks/bonds or some variation, and used a few vehicles (primarily direct ownership of equity shares and mutual funds) to implement their strategies.

Then about 30 years ago, several developments conspired to complicate the matter of asset allocation. The Efficient Market Hypothesis, EMH, coupled with the Capital Asset Pricing Model, CAPM, encouraged investors to seek the proverbial free lunch of increased returns without increased risks, through diversification into uncorrelated assets. At the same time, new financial instruments-from financial futures, to an explosion in mutual fund choices, to separately managed accounts, to ETFs-began to proliferate. Equities were suddenly classified by size, geography, and "style," while financial advisors were forced to pretend that each was its own asset class. In recent years, "alternative investments" have become a separate line item on many asset allocation templates.

ETFs and hedge funds have made it particularly challenging for investors to define asset classes, since many of these funds can be classified several ways, depending on the underlying instruments, the strategy, shorting ability, or markets in which they invest. For example, should a long-short value equity hedge fund be categorized as "alternative" or just as "equity"? Does a volatility ETF, such as VXX, give you access to an asset class? These questions are not trivial in any environment, but they are especially crucial when correlations between historically separate asset classes are high and investors are looking to diversify. Even within certain asset classes, such as stocks, correlations are at historic highs. Consider the following chart, posted on The Big Picture:

Click to enlarge

With correlations of stocks at historic highs and implementation vehicles for esoteric products so readily available, investors might be tempted to seek returns in seemingly-alternative asset classes. Yet, at what point is an implementation vehicle just a speculative bet, and not part of an investment strategy? Moreover, when correlations are at historic highs within an asset class, will specialty exposure really trump investing in the index? Earlier this week, I learned about two new ETFs that invest in stocks based on insider activity: KNOW and INSD. I have no position in either, and I'm curious about what (or whether) investors in these ETFs will gain when correlation within the S&P 500 is so high. Wouldn't adding these ETFs to your equity exposure in this environment just be adding correlated beta exposure without adding any of the diversification benefits?

The issues of categorization, niche exposure, and benchmarking have become increasingly prevalent for me over the past few years, as my clients inquire about different ETFs that pop up almost daily. Consider inverse ETFs, for example, which can be useful as hedging instruments, but are NOT an asset class. While the employment of inverse ETFs, such as ProShares Short S&P 500 (SH), requires an active decision within an asset class (i.e. "equity" allocation), it does not actually represent a new "alternative" exposure; instead, it is a reduction of exposure within a class, and an increase in operational risk in the instrument.

Investopedia defines an asset class as "a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments)."

If this description is mostly accurate (which I think it is), then seeking exposure to real estate through REITs is not the same as buying real estate directly, because REITs will tend to act the same and be exposed to the same regulations and factors as other equities. Similarly, the levered fixed income hedge fund that uses complex securities is not much more than an active mutual fund in your fixed income allocation. While we can debate whether traditional mutual funds should take a more active approach to investing, the salient point is that both funds are playing in the same sandbox, and will be impacted by the same marketplace dynamics, regulations, and factors.

If you're looking for niche exposure, sector rotation, leverage, or hedging strategies, the current menu of choices is endless, and it's a net positive for investors. However, no matter how slick a new instrument sounds or looks, if it's drawing on the same pool of instruments, then you want to make sure you don't increase your exposure to those underlying instruments inadvertently and throw off your entire asset allocation. Because just at the moment when you need diversification the most, and are depending on lack of correlation to save your portfolio, and just when you need your asset allocation to come to the rescue, you might discover that those new investments have the same downside with none of the benefits. Investors and advisors need to start looking through the investments to the underlying instruments and then build worst-case scenarios without assuming that correlations remain low and stable.
Editor's Note: We're pleased to introduce our new columnist, Yaron Sadan of Osher Capital Advisors, LLC (Osher). Yaron also writes and edits The Hard Trade, a financial newsletter focused on risk and asset allocation, behavioral finance, contrarian investing, global macro-economic themes, and geopolitics.
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No positions in stocks mentioned.

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