Strategic asset allocation is arguably the most important set of decisions a portfolio manager can make.
Selecting the target long-term asset mix serves at least two purposes. If the portfolio manager takes an active approach to investment decisions, the allocation process allows him to choose the class of assets he thinks will most likely increase in value over the relevant horizon. If the manager takes a more passive approach, then the asset allocation process is still used to bring controlled diversification to the portfolio, which should decrease its volatility.
But before allocating a portfolio to various classes, a manager must first identify the asset classes to be considered. This, in turn, requires a definition of what constitutes an asset class, and how that definition applies to real world investment alternatives. It shows effective portfolio managers must expand their framework beyond "capital assets."
Defining an asset class
An asset class is a set of assets that bear some fundamental economic similarities to each other, and have characteristics that make them distinct from other assets that are not part of that class. It is not sufficient that values of a group of assets simply have a low historical correlation with the values of another group of assets. If that were the case, then a collection of stocks with very low (or negative) betas would be considered an asset class separate from those stocks that make up the broader market indexes. Perhaps low beta stocks constitute a different sector within the asset class of domestic equities, but they would hardly make up a class of assets in and of themselves.
In making the determination of what constitutes an asset class, the investment manager needs also to distinguish between the assets themselves and financial instruments derived from those assets. For instance, a stock option is an instrument derived from equity, which is a fundamental asset.
Within this framework, what are definable asset classes? At the broadest level, there are three:
The lines between these "superclasses" sometimes blur, and there are indeed some hybrid assets. But these three superclasses each has distinctive fundamental economic features, and they collectively cover the universe of assets to which the portfolio manager might wish to be exposed. Each superclass, of course, can be further divided into traditional classes and sectors, but that more detailed issue is only briefly treated here.
A capital asset is an ongoing source of something of value. One class of capital assets - equities - provides the expectation of an indefinite stream of dividends. Another category of capital assets - bonds - provides the expectation of a stream of interest payments, along with the residual return of principal, which can then be reinvested. One way in which capital assets are therefore valued is by the net present value method - discounting that expected stream of value.
By this definition, income-producing real estate is certainly a capital asset. It provides an ongoing stream of net operating income, along with a residual value. Real estate often is held directly, rather than through a financial derivative, and it has other common economic characteristics that, in the minds of many, make it a class of asset that is distinct from other capital assets.
Foreign debt and equity, which also are capital assets, can be greatly influenced by forces in their domestic economies. This supports the case for subclasses of debt and equity based on economic regions of the world.
A capital asset can reasonably be valued based on the net present value of its expected returns. Therefore, everything else being equal, a financial capital asset will decline in value as the investor's discount rate increases, or rise as that rate decreases. This economic characteristic unifies the superclass of capital assets.
You can consume it. You can transform it into another asset. It has economic value. But it does not yield an ongoing stream of value. That is the functional definition of a consumable/transformable asset.
The profound implication of this distinction is that C/T assets, because they are not capital in nature, can't be valued using a net present value form of analysis. This makes them truly economically distinct from the superclass of capital assets. C/T assets must be valued more often based on the particular supply/demand characteristics of their specific market.
Another distinction between capital and C/T assets is that many C/T assets, such as those whose futures are traded on commodity exchanges, are subject to global more than regional supply/demand factors. Allowing for transportation and handling costs, the value of a similar grade of wheat or crude oil will be highly correlated in various parts of the world. While supply may be regionalized, demand is worldwide, and the commodities are economically transportable.
The primary mechanism used by investors to gain exposure to these assets is a commodity futures contract, which is derived from the C/T asset superclass. Attempts have been made to analyze prices of these C/T assets or their futures derivatives in the context of the Capital Asset Pricing Model. But a recognition of the economic distinctness of C/T assets leads to the conclusion that the rules of CAPM do not necessarily apply.
C/T assets, whose values are not driven nearly as much by discount rates as are capital assets, are economically very distinct from the traditional classes of stocks, bonds and real estate. Therefore, they offer both diversification and meaningful choice to the portfolio manager.
The third superclass of asset can't be consumed, or generate income. It is a store-of-value asset. One example is fine art. There is certainly aesthetic value to a fine sculpture, but rare is the owner who does not also expect the sculpture to be worth something in monetary terms.
A broader and more relevant example is the category of foreign currency (as distinguished from equity and debt instruments denominated in a foreign currency). Absent currency and other restrictions, an investor will hold a Japanese yen, for instance, instead of a U.S. dollar if he thinks the yen is a better store of value. That yen can then be used to purchase a capital asset (e.g., equity or a debt instrument) denominated in yen. But the yen itself is a store of value.
Instruments tied to asset classes
Within this conceptual framework, the lines between asset classes can still be fuzzy.
The lines get even fuzzier when we analyze financial instruments derived from these asset classes. Unhedged foreign bonds, for instance, are capital assets but also use the foreign currency as a store of value. The framework presented is still useful to a portfolio manager in making asset allocation decisions. First he can decide the broad exposure he wants to these three superclasses of assets, and the subclasses within them. He can then choose the instruments to use, and perform further sector analysis.
The range of instruments for debt and equity is well known and therefore is not discussed here, except to say that the investment manager should assess the instrument in terms of its exposure to changes in value of the underlying asset class. The instruments for store-of-value exposure, when referring to foreign currencies, also are well known. Currencies are the best known and most widely used assets in this class, and the exposure is often gained through a financial capital asset - a debt or equity instrument denominated in the foreign currency.
The more esoteric and illiquid store-of-value assets, as the classification implies, are simply bought and held indefinitely. Institutions traditionally have stayed away from these assets because they are difficult to manage and evaluate. In addition, there is often some value other than monetary value associated with many of these assets. This non-monetary value is not useful to most institutional investors.
Instruments used to gain exposure to C/T assets are less well known. The most obvious possibility might seem to be actual ownership of the physical asset. But that is management-intensive, holding costs are often excessive, and there may not be a highly liquid market for some of those C/T assets.
The next possibility is the ownership of equity in "natural resource" companies.
While some institutions have taken this approach, the prices of stocks in those companies are affected by many factors other than the price of the C/T assets the company controls. Chief among those other determinants is the overall movement in stock market prices. The value of the stock is also affected by the financing structure of the company, and related moves in interest rates.
Companies producing C/T assets also will reflect operating leverage. For instance, a 10% downward move in the price of copper could throw a marginal producer into a loss position. Finally, the price of the stock will be affected by the quality of management, and by activities other than C/T asset ownership in which the company is engaged.
The third way in which investors gain exposure to C/T assets is by use of the commodity futures markets, and derivatives of those markets. Use of an unleveraged index of commodity prices is the most typical way in which this is done. Only the futures of physical commodities (hard assets) are used, and a long position is constantly maintained in those markets. Collateral equal to the full value of the futures contracts is maintained, and invested in Treasury bills to provide a current return as well. The exposure is passive and broad-based, and the position can be readily valued because it is determined by the prices of exchange-traded assets.
The specific instrument that is most commonly used at the institutional level is a commodity-linked note. In its simplest form, this is a zero-coupon note whose value at maturity will be a function of the value of the index to which it is linked, compared to the value of the index at the time the note was purchased.
Not only does this instrument have a readily ascertainable value throughout its life, but it avoids the necessity and complexity of directly managing a commodity futures investment. Note that this instrument becomes a financial capital asset derived from a C/T asset, and it reflects changes in C/T values.
The difference between a commodity index and a "managed futures account" cannot be stressed strongly enough.
The latter, with the right choice of managers, might indeed provide an attractive return. But a managed futures account does not fit the definition of an asset class. The managed account might be using leverage in its positions, and it is likely to have positions in currencies and financial futures as well as the futures of C/T assets.
Furthermore, depending on the manager's trading method, the account will sometimes be long a market, sometimes be short that same market, and at other times it may have no position at all. If you cannot read the morning paper and know whether certain market movements were good or bad for your portfolio, then you do not have the consistency of economic exposure that is required of an asset class.
Asset classes are distinguished by the characteristics of their economic exposure. Assets within the class therefore have shared systematic risk, but they are not defined simply by their historical statistical correlation to each other. Debt, equity, and real estate are asset classes within the superclass of capital assets. Because the value of a capital asset can be strongly affected by forces in the regional economy of which it is a part, many capital asset classes have a geographic dimension as well.
Further, when these assets are denominated in foreign currencies (unhedged), they have a store-of-value component (vs. the dollar). All of these capital assets will be affected by perceived discount rates, and changes in those rates.
Consumable/transformable assets are an additional distinct asset superclass. Values of C/T assets are driven by economic factors distinct from the factors determining capital asset values - the ultimate desirable characteristic for diversifying a portfolio. Ownership of a commodity-linked note, especially if it is linked to a broad-based index, provides a pure and consistent exposure to this asset class that can be liquid, easy to value and easy to manage. Historically, the benefits to a portfolio of investment in this asset class have been shown to reduce volatility and often to increase portfolio return at the same time.
A third superclass, store-of-value assets, offers currency diversification to the portfolio. It is typically represented by foreign-denominated capital assets.
There are implications to these concepts that go beyond the scope of this article. For instance, what is the appropriate analytical structure for assessing the impact of non-capital assets on a portfolio? If C/T assets can't be valued by CAPM, then do they have betas, and what would those betas mean?
But first, portfolio managers who want maximum efficient diversification must identify the full range of asset classes.