Posts tagged ‘CAPM’

Not all assets are classes

Written December 8th, 2011

Asset allocation used to be easy. There were three main asset classes investors had to contend with: cash, bonds, and equities. Most investors could rely on a 60/40 portfolio of stocks/bonds or some variation, and used a few vehicles to implement their strategies (stocks and mutual funds, primarily).

About 30 years ago, a few 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 look for the proverbial free lunch, by diversifying into uncorrelated assets to increase return without increasing risk. At the same time, new financial instruments began to proliferate, from financial futures, to an explosion in mutual fund choices, to separately managed accounts, to ETFs. Equities were suddenly broken down by size, geography, and “style”, and financial advisors were forced to pretend that each was its own asset class. More recently, “alternative investments” became a line item on many asset allocation templates.

ETFs and hedge funds have made it particularly challenging to define an asset class. For example, should a long-short hedge fund be categorized as “alternative” or just as “equity”? Is a volatility ETF, such as VXX, giving you access to an asset class? These questions are not trivial in any environment, but are even more crucial in one where correlations between historically separate asset classes is high and investors are looking to diversify. Even within certain categories, such as stocks, correlations are at historic highs. The following chart was posted on The Big Picture:

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

These issues have become more prevalent for me as clients ask about different ETFs that pop up almost daily. Inverse ETFs, for example, can be useful as hedging instruments, but they are NOT an asset class. When we use inverse ETFs, such as SH (short S&P 500 exposure) it is still categorized under the “equity” allocation. It is an active decision within an asset class, but does not represent a new “alternative” exposure.

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).” In that light, getting exposure to real estate through REITs is not the same as buying real estate directly, and the levered fixed income hedge fund that uses complex securities is not much more than an active mutual fund in your fixed income allocation. Perhaps the traditional mutual fund should take a more active approach, but both funds are playing in the same sandbox, and will be impacted by the same marketplace dynamics, regulations, and factors. -Investors need to start looking through the vehicle to understand the underlying instruments used.