In deciding upon the suitable set of asset classes, we followed the below criteria. They must:
- Cover the vast majority of liquid asset types found in investment portfolios/funds to be mapped;
- Distinguish between unique types of assets (i.e. "Equity" may be considered too broad, and thereby lump together sub-asset-classes with very different characteristics, whilst "UK Small Cap Utilities" may be considered too specific);
- Be usable in projecting long term return paths. There must be representative indices available, with monthly returns data stretching back as far as the risk engine requires.
- Exhaust the additional benefit from including further granularity into the asset class set
Asset Classes
Cash
As the "risk-free" asset, cash is not split into any sub-components. It should consist solely of liquid, high credit
quality, very low duration assets such as bank deposits, money market funds, etc.
Fixed Income
There are two major factors affecting prices: interest rates (duration of the bond), and credit quality. Duration can be seen as roughly analogous to equity beta, in the sense that longer duration bonds are more responsive to changes in interest rates. Credit quality offers another source of potential return through the additional yield on offer to compensate for the extra risk.
Typically, investment funds/portfolios are not broken down by duration, but by credit quality. It therefore makes sense to split Fixed Income by credit quality first and foremost: into Investment Grade and High Yield.
Within the Investment Grade section, it makes sense to further split between Government- and Corporate-issued debt. This is because sovereign bonds are considered considerably less risky than their corporate cousins; only central banks have the power to print money to avoid default, albeit at the cost of inflation. Thus, government bonds are usually perceived as offering only interest rate risk, with de minimis credit risk.
When considering emerging market debt: this will most usually be high yield, and fall naturally into the High Yield Bonds asset class. However, on occasion there may be investment grade EM credit to reflect.
Equity
Although arguably the more important attribute of equity assets is the industry or sector in which the company operates, most funds/portfolios do not organise on this basis.
Most equity funds will be described in terms of their specific country focus, however it is better to first of all differentiate according to whether the country in question is a developed or emerging market (typically defined as per the MSCI schema).
We opt not to split equity any further into specific countries, as inter-country correlation is very strongly positive.
There is an open question as to whether to distinguish between large/mid/small caps, as there is certainly a risk differential here. However, it is much smaller than the DM/EM divide, so we split only the latter.
Alternatives
The question of what exactly constitutes an "alternative" asset is open to interpretation. However, it usually involves some combination of property, commodities, and hedge funds, and so we consider each of these separately.
There are many other potential candidates, of course, however these three are believed to account for the vast majority of non-traditional asset classes found in liquid investment portfolios. Besides, highly idiosyncratic asset classes may be difficult to project performance for, and in any case can be addressed through our alternative methodology.
Property
Ever a controversial asset class, the dilemma of property is that the only way to represent it as an index is not particularly useful. Whereas most investors think of property as being "bricks and mortar" residential and commercial real assets, in practice it is very difficult to reflect such investments in a liquid index - due to e.g. taxes, fees etc.
Consequently, the only scalable way to represent property in a liquid portfolio is to use Real Estate Investment Trusts (REITs). However, these are, to all intents and purposes, merely equities within the "Real Estate" sector (the correlation is extremely strong and positive). Thus, one is not especially gaining diversification from an "alternative" asset - there is simply too much equity sentiment contaminating the returns. However, for the time being, given the ubiquity of Property within liquid multi-asset portfolios, we include it as an asset class, and use a REITs index for the purpose - cognisant of the limits of this approach.
Commodities
Whilst some argue for the inclusion of gold as a primary commodity diversifier, it is ultimately a poor inflation hedge (see its long term real value), only offering returns in the emphatically unusual times when markets start to panic. Gold has become a currency, to an extent, and tends to be popular amongst traditionalist investors averse to debasement of fiat currencies through quantitative easing (QE) etc. It therefore does well when stock markets are making headlines for the wrong reasons - less well the rest of the time. Given its esoteric appeal, it is less of an asset class and more of a cult investment.
Oil is perhaps the most-felt commodity, given its ongoing (though diminished) link to global economic growth. However, even more so than gold, it is very difficult (almost impossible) to own directly; one invests in it through forwards. Like gold, it is but one commodity amongst many.
We therefore include commodities as a broad asset class in its own right. Commodities generally do exhibit diversifying properties (i.e. grant exposure to factors not generically present in equities or bonds). They can be a hedge against short term inflation, by virtue of often being the very cause of such inflation. But as a long term hedge, they are poor, and their returns have been miserable for several years now. Thus, one may well question their inclusion in a long term multi-asset portfolio. However, our role in this context is not to construct portfolios but to ascertain their risks. For this purpose alone, we retain Commodities as an asset class.
Hedge Funds
Another controversial asset class: can one legitimately group together disparate investment management styles - from merger arbitrage to global macro to relative value - under one umbrella? Furthermore, how can one represent well such investments given the changing regulatory landscape - from the Wild West of the 90s through to the UCITS-dominated, low vol era of the 2010s and beyond? Has all the alpha been swallowed? The aforementioned concerns notwithstanding, we nonetheless continue to include Hedge Funds as an asset class in deference to their continuing presence amongst some - though not all - liquid multi-asset funds, wherein they typically take the form of funds of underperforming funds.
The Final Roster
The final selection of asset classes is as follows:
1. Cash
2. Investment Grade Government Bonds
3. Investment Grade Corporate Bonds
4. High Yield Bonds
5. Developed Equity
6. Emerging Equity
7. Real Estate
8. Commodities
9. Hedge Fund