Journal of Financial Planning: September 2012
The most typical definition of an asset class is a group of securities that have similar risk/return characteristics and behave similarly in the marketplace. Thus, for instance, stocks, bonds, and cash represent the three most common asset classes, as each has different risk/return characteristics and behaves very differently in response to various economic and market events.
One of the most common ways to determine whether an investment represents a unique asset class is to examine its correlation with other investments. After all, two investments that have different risk/return characteristics and behave differently in response to market events would likely show little similarity in returns over time, thereby exhibiting a low correlation. Given how modern portfolio theory demonstrates that investments with a low correlation to the rest of the portfolio can lower the overall volatility of the portfolio—even if the underlying investment itself is volatile—advisers have increasingly sought out low correlation “alternative” asset classes and investments to manage risk through diversification.
The caveat, however, is that in an increasingly complex financial world, having a low correlation alone can actually be a remarkably poor and misleading indicator of what constitutes an alternative asset class.
Instability of Correlations
One of the primary problems with using correlation as a measure to determine what may be an alternative or different asset class is the fact that correlations themselves are often unstable. For instance, as many advisers noticed in late 2008, many asset classes that were previously low correlation actually had a very high correlation during the market decline. The end result, at least in retrospect, was that a number of asset classes were actually low correlation to stocks during the bull markets but high correlation during bear markets—which means they were a drag on returns when markets were up, yet provided little diversification value when needed. The reason? Because in the end, the asset classes were still subject to the same underlying risk factors; and when those factors, including an economic recession and a contraction of credit, actually did occur, many asset classes previously thought to be separate moved in sync. The bottom line is that a low correlation only matters if it’s expected to be low when it’s needed, not just on average.
It’s also important that the correlation be genuinely low in the first place. In a world where correlations have crept higher across many asset classes over the past several decades, so too has the threshold for what a “low” correlation really is. While at one time correlations had to be 0.2–0.4 to be considered “relatively low,” many advisers now view 0.5–0.7 as being fairly low ... despite the fact that in the end, such correlations wouldn’t have been truly expected to produce much diversification even with traditional portfolio design.
Low Correlations Through Active Management
Another confounding factor to using correlation as a means of determining whether something is an asset class is the fact that some investments are actively managed, which leads to the possibility that low correlations may simply be a result of the varying decisions of the investment manager, not a difference in the underlying characteristics of the investment.
Historically, this hasn’t necessarily been an issue; “actively managed equities” has never been viewed as a different asset class than equities, but simply represents the opportunity for the manager to add (or subtract) alpha, on top of the underlying returns of the asset class itself. However, in today’s environment with an increasing number of “go-anywhere” investment managers, the situation is less clear. An investment manager who was in cash in 2008 and equities in 2009 would show a very favorable return, but would exhibit a relatively low correlation to cash (because half the time was in equities) and a relatively low correlation to equities (because half the time was in cash).
If the fund was simply a balanced fund that maintained a 50/50 exposure to stocks and bonds, it would be relatively straightforward to see that the fund represents not a new asset class, but simply a 50/50 exposure of two underlying asset classes. However, the reality is that when the manager chooses how much or whether to invest in each underlying asset class, and shifts over time, the correlations may decline but the asset class of the fund itself hasn’t changed—just the allocations. As a result, it arguably may be more effective to evaluate such funds relative to the asset class of their benchmark—what they intended to mimic or track before adding or subtracting alpha—rather than what the manager (temporarily) holds. After all, if a fund’s goal is to beat the equities asset class, which it does by holding equities except when they are risky and overvalued and cash represents a better investment opportunity, does the asset class of the fund change the day it shifts to cash, or just its short-term allocation?
Trying to Determine an Alternative Asset Class
So how should a planner determine whether an investment constitutes a unique asset class or not, especially given the rising popularity of “alternative” asset classes?
The key is a return to the original definition of an asset class: a group of investments that shares common risk/return characteristics and behaves similarly in response to economic and market events. If an investment meets these criteria, then it should also have a low correlation to other asset classes. However, as shown earlier, a low correlation alone is not a sufficient criterion for determining an asset class, as there are many factors that can result in a low correlation that have little to do with what defines an asset class (and/or may not represent a distinct asset class at the time it’s needed!).
When we look to the underlying investment characteristics, some asset classes meet the test far more effectively than others. For instance, real estate and commodities have unique characteristics, are driven by economic and market fundamentals that are different from other traditional asset classes, and while they happened to move in sync during the 2008 financial crisis, they clearly would not have a high correlation in all economic environments. For instance, while stocks, real estate, and commodities may move in lockstep during a deflationary environment (while government bonds go the other way), a rising inflationary environment can send commodities soaring while stocks, bonds, and real estate take a hit (at least, until their prices/rents can adjust and generate higher revenues). Real estate may also be sensitive to interest rates, which affects the capitalization rate that affects real estate prices, in a manner that is similar to bonds but very different from how interest rates affect commodities or equities.
On the other hand, in some situations the lines are less clear. Large capitalization stocks are often viewed as a separate asset class from smaller capitalization stocks, even though both will typically rise in a growth environment and decline in a recession (at least, unless there are significant differences in valuation). Similarly, there is much debate about whether sectors of the economy—such as utilities versus technology stocks—constitute separate asset classes or not. While they are both equities, the reality is that their correlations may be lower and their returns may actually diverge more through an economic cycle than large- versus small-cap stocks; technology stocks often rise and fall with the economy, while utilities typically move in a “counter-cyclical” fashion.
An especially problematic scenario for evaluating asset classes is the emergence of many “hedge fund strategies” funds and managed futures investment offerings, that often mix together multiple asset classes to begin with, along with shifting allocations over time, to generate low correlations to traditional asset classes. Yet if actively trading equities is not a separate asset class than equities in general, does that mean actively trading commodities is not a separate asset class from
commodities, in the case of many managed futures funds? If the fund shifts between commodities, stock, and interest rate futures, does that constitute a new asset class, or simply a combination of the underlying, existing asset classes? If the goal of a merger arbitrage fund is to generate returns in excess of cash while neutralizing market risk, even though the underlying investments are equities, does that mean it’s a stock asset class, a cash asset class, or an entirely separate asset class? What about other active hedge fund strategies?
What do you think? Do you consider large-cap stocks a different asset class than small-cap stocks? What about utilities versus technology stocks? Are managed futures and hedge fund strategies a new alternative asset class, or just the active trading of the underlying asset classes? What makes something an asset class? Is it just a low correlation, or does it require something more?
FPA members can discuss these and other questions with your colleagues on the “All Member Open Forum” community on FPA Connect, at Connect.FPAnet.org.
Michael E. Kitces, CFP®, CLU, ChFC, RHU, REBC, is a partner and the director of research at Pinnacle Advisory Group, a private wealth management firm in Columbia, Maryland. He is the publisher of The Kitces Report and the blog Nerd’s Eye View through his website www.Kitces.com, and practitioner editor for the Journal of Financial Planning. Follow him on Twitter at @MichaelKitces.