tracking error of a portfolio composed of these asset classes with intermediate-term bonds is only 1.1%. Intermediate-term bonds are, therefore, redundant. The lowest possible tracking error with commodities, by contrast, is 19.5%; hence, we include commodities in our menu of asset classes. Although there is no generically correct tracking error threshold to determine sufficient independence, within the context of a particular group of potential asset classes the answer is usually apparent.
EXPECTED UTILITY
The addition of an asset class to a portfolio should raise the portfolio's expected utility. This could occur in two ways. First, inclusion of the asset class could increase the portfolio's expected return. Second, its inclusion could lower the portfolio's risk, either because its own risk is low or because it has low correlations with other asset classes in the portfolio.
The expected return and risk properties of an asset class should not be judged only according to their average values across a range of market regimes. A particular asset class such as commodities, for example, might have a relatively low expected return and high risk on average across shifting market regimes, but during periods of high financial turbulence could provide exceptional diversification against financial assets. Given a utility function that exhibits extreme aversion to large losses, which typically occur during periods of financial turbulence, commodities could indeed raise a portfolio's expected utility despite having unexceptional expected return and risk properties on average.
It might occur to you that in order to raise a portfolio's expected utility, an asset class must be externally heterogeneous. This is true. It does not follow, however, that all externally heterogeneous asset classes raise expected utility. An asset class could be externally heterogeneous, but its expected return may be too low or its risk too high to raise a portfolio's expected utility. Therefore, we could have omitted the criterion of external heterogeneity because it is subsumed within the notion of expected utility. Nevertheless, we think it is helpful to address the notion of external heterogeneity explicitly.
SELECTION SKILL
An asset class should not require an asset allocator to be skillful in identifying superior investment managers in order to raise a portfolio's expected utility. An asset class should raise expected utility even if the asset allocator randomly selects investment managers within the asset class or accesses the asset class passively. Not all investors have selection skill, but this limitation should not disqualify them from engaging in asset allocation.
Think about private equity funds, which are actively managed. Early research concluded that only top-quartile private equity funds earned a premium over public equity funds.1 If this were to be the case going forward, private equity would not qualify as an asset class, because it is doubtful that the average asset allocator could reliably identify top-quartile funds prospectively, much less gain access to them. More recent research, however, shows that private equity funds, on average from 1997 through 2014, outperformed public equity funds by more than 5% annually net of fees.2 If we expect this level of performance to persist, private equity would qualify as an asset class, because an asset allocator who is unskilled at manager selection could randomly select a group of private equity funds and expect to increase a portfolio's utility.
COST-EFFECTIVE ACCESS
Investors should be able to commit a meaningful fraction of their portfolios to an asset class without paying excessive transaction costs or substantially impairing a portfolio's liquidity. If it is unusually costly to invest in an asset class, the after-cost improvement to expected utility may be insufficient to warrant inclusion of the asset class. And if the addition of the asset class substantially impairs the portfolio's liquidity, it could become too expensive to maintain the portfolio's optimal weights or to meet cash demands, which again would adversely affect expected utility.
Collectibles such as art, rare books, stamps, and wine may qualify as asset classes for private investors whose wealth is limited to millions of dollars and who do not have liquidity constraints, but for institutional investors such as endowment funds, foundations, pension funds, and sovereign wealth funds, these collectibles have inadequate capacity to absorb a meaningful component of the portfolio. This distinction reveals that the defining characteristics of an asset class may vary, not in kind, but in degree depending on an investor's circumstances.
POTENTIAL ASSET CLASSES
We believe the following asset classes satisfy the criteria we proposed, at least in principle, though this list is far from exhaustive.
| Cash equivalents | Foreign developed market equities |
| Commodities | Foreign emerging market equities |
| Domestic corporate bonds | Foreign real estate |
| Domestic equities | Infrastructure |
| Domestic real estate | Private equity |
| Domestic Treasury bonds | Timber |
| Foreign bonds | Treasury Inflation Protected Securities (TIPS) |
The following groupings are often considered asset classes, but in our judgment fail to qualify for the reasons specified. Obviously, this list is not exhaustive. We chose these groupings as illustrative examples.
| Art | Not accessible in size |
| Global equities | Not internally homogeneous |
| Hedge funds | Not internally homogeneous and require selection skill |
| High-yield bonds | Not externally heterogeneous |
| Inflation | Not directly investable |
| Intermediate-term bonds | Not externally heterogeneous |
| Managed futures accounts | Not internally homogeneous and require selection skill |
| Momentum stocks | Unstable composition |
Let's focus on hedge funds for a moment, since many investors treat this category as an asset class. Most hedge funds invest across a variety of asset classes; thus, they are not internally homogeneous. Moreover, they comprise actively managed variants of other asset classes, so they are not externally heterogeneous. Finally, it is unlikely that a random selection of hedge funds will improve a portfolio's expected utility. Rather than treating hedge funds as an asset class, investors should think of them as a management style. The decision to allocate to hedge funds, therefore, should be a second-order decision. After determining the optimal allocation to asset classes, investors should next consider whether it is best to access the asset classes by investing in passively managed vehicles, active separately managed accounts, mutual funds, limited partnerships, or hedge funds.
In the next chapter, we describe the conventional approach to determining the optimal allocation to asset classes.
REFERENCES
1 Kaplan, S. and Schoar, A. 2005. “Private Equity