Asset Classes, Risk, and Return: A Post-Modern Perspective
Asset classes are the building blocks used to construct an investor’s strategic asset allocation. By arranging these blocks astutely, an investor can diversify portfolio risks and improve his chances of achieving personal financial goals.
Traditionally, investors focused on three major asset classes: Cash, Fixed Income, and Equities, mixing those asset classes according to personal income and liquidity needs and constraints. In the second half of the twentieth century, highly quantitative methods were developed to help investors “optimize” their portfolios into an efficient mix of expected risks and returns.
In addition, new asset classes were added to the menu of potential investments (e.g., Hedge Funds, Private Equity), while traditional asset classes were divided into more granular asset sub-classes (e.g., Investment-Grade Bonds, High-Yield Bonds, Emerging Markets Bonds).
With more sophisticated allocation tools and a wider selection of available investment strategies, it is not surprising that investors devoted a greater percentage of their portfolios to supposedly “low correlation” assets promising protection against market downturns. These included Hedge Funds, certain commodities-based investments, structured products, credit-related instruments, and leveraged or inverse strategies.
The Financial Crisis proved that asset class correlations are themselves highly volatile, and that portfolios based primarily on expectations of low correlation among asset classes may suffer significant losses when systemic risks overwhelm financial markets. In cases of extreme market turmoil—such as 2008—asset classes become highly correlated one with another and the benefits of asset class diversification were, in many cases, severely diluted.
For investors, one of the lessons of the Financial Crisis is that asset class labels, as commonly applied, do not adequately capture and convey the information we need to properly construct our individual portfolios. The label “Hedge Funds,” for example, gives us few clues regarding the nature, scope, or level of risks we might encounter when investing in the asset class. Similarly, the variety of investments labeled “Real Estate” range from the income-oriented to the highly speculative, from the highly stable to the extremely cyclical, and from single, directly-owned properties to diversified global funds.
If we are to utilize a Goals-Based framework in determining the most appropriate asset allocation—an allocation maximizing the probability of achieving our individual goals—we will require a new paradigm for classifying and considering investments. That new paradigm should be based on how specific investment strategies behave, rather than on traditional asset class labels. How investments behave can be measured across multiple dimensions:
- Liquidity: how quickly can the investment be turned into cash without taking a “haircut” on price?
- Volatility: how wide is the range of past and expected future outcomes for the investment, both in absolute and relative terms?
- Duration: how sensitive is the investment’s value to changes in interest rates and inflation?
- Geography: on what country, region, or continent are the investment’s risks and returns primarily dependent?
- Directionality: to what extent does the investment utilize techniques to hedge market-related risks?
- Passivity: how closely are past and expected investment returns linked to those of particular market indices, versus to manager-specific decisions?
In the Goals-Based framework, the ideal mix of these investment dimensions is heavily dependent upon the timing and priority of our individual goals. When funding personal goals having a near-term time horizon and a high personal priority, certainty in the dollar amount and availability of cash is the primary factor. Therefore, the dimensions of Liquidity and Volatility should govern our allocation of assets to fund these goals.
In determining the ideal asset allocation to fund long-term goals (10+ years), the dimensions of Geography and Directionality are important, reflecting the dependence of long-term returns on underlying economic growth trends in invested markets (Geography) and upon the degree to which the portfolio has unhedged exposure to those markets
(Directionality). In a Goals-Based framework, investors should focus less on asking what percentage of their portfolio is allocated to Fixed Income or Equities or Hedge Funds, and more on asking the following questions: What percentage of my portfolio is in Liquid vs. Non-Liquid assets? What percentage of my assets are allocated to High Volatility vs. Low Volatility investments? To what extent are my investment returns linked to a specific Geography? Are my investments more dependent upon underlying market returns or on specific manager decisions?
These questions focus on the behavior of our investments rather than on increasingly vague asset class labels. Investors who view their investments by these behavioral dimensions increase the probability of meeting their stated financial goals, especially in turbulent markets.
