Asset Classes versus Tilts

A number of readers have written to us to ask about why, for example, we don't recommend value oriented index funds in our model portfolios. Based on the assumption that is someone has written us about an issue, a lot more people are thinking about it, we thought it would be helpful to address this issue again.

How you choose to allocate your investments between different types of assets (that is, between "asset classes") is the most important decision you make when it comes to determining whether or not over time you will earn the minimum rate of return you need to meet your goals. Unfortunately, this "asset allocation" decision is one that most people don't spend nearly enough time thinking about before they make it.

Given this, let's start with the basics. First, what is an asset class? To some extent, this is a theological question, on which experts can argue for hours without reaching agreement. For example, you may hear some people define "mid-cap U.S. value stocks" as an asset class, while someone else calls "European stocks" or "U.S. government bonds" an asset class. The basic concept of an asset class is relatively straightforward. An "asset class" is a group of securities of some type that have more in common with each other than they do with securities from outside the group. The rate of return on an asset class is measured by an index. So far, so good. But how and where does one draw the lines? What does "have more in common with each other" mean in practice?

Here is how we've approached this question at The Index Investor. The basic purpose of dividing securities into asset classes is so that they (the asset classes) can be combined into portfolios that are "optimal." In this case, optimal means that there is not another combination of asset classes that is expected to generate a higher ratio of return to risk (for those of you who are familiar with modern portfolio theory, we're talking about the efficient frontier).

When you are calculating the expected return and risk of different portfolios (that is, different combination of asset classes whose weights sum to 100%), return is pretty easy to calculate: it is simply the weighted average of the expected returns of the different asset classes included in the portfolio. Calculating risk, however, isn't as easy. Why? Because the riskiness of an asset class depends not only on how variable its returns are relative to their historical average (that is, their standard deviation), but also on the extent and direction in which the asset class's returns vary with those of other asset classes (that is, their correlations). For example, an asset class with a relatively low rate of return might be a very good one to hold in a portfolio if those returns tended to go up when other asset classes' returns went down.

This brings us to the crux of the argument about what constitutes an asset class: the real question (in our eyes, at least), is where you draw the line on the maximum correlation of returns you will accept between two "asset classes." Consider the following correlations (of monthly returns from January, 1988 through December, 2000). Between the Russell 3000 (an index that measures the performance of the broad U.S. equity market) and the S&P 500, the correlation of returns was .99; with the S&P 400 (a mid-cap index) it was .92, and with the Russell 2000 (a small cap index) it was .78. However, the Russell 3000's correlation with the Lehman Brothers Aggregate Bond Index (a broad measure of returns in the U.S. bond market) was only .38; with the MSCI Europe Index (which measures returns on European equities), it was .61, and with the MSCI Emerging Markets Index (emerging market equities) it was .55.

Given that the real power of diversifying your portfolio across asset classes comes from reducing risk as much as it does increasing returns, at The Index Investor we think it makes sense to define the asset classes used in our model portfolios broadly enough so that their returns have a relatively low degree of correlation with each other. So for our purposes, European, Emerging Markets, and U.S. Equities (represented by the Russell 3000) are asset classes, while the S&P 500 (a large cap U.S. equity tilt) or the Russell 2000/Value (a small cap/value U.S. equity tilt) are not.

There is one final reason for our use of broadly defined asset classes in our portfolios. As we have described above, defining asset classes narrowly (for example, defining large capitalization and small capitalization U.S. equities as separate asset classes) results in very high levels of correlation between asset class returns. When these are used as inputs into our asset allocation models, the high correlations cause the results to be extremely sensitive to small changes in each asset classes' estimated risk and return. When this happens, small changes in expected returns often result in large changes in recommended asset class weights. Given that these risk and return estimates themselves are relatively uncertain (see the next article), using narrowly defined asset classes whose returns are highly correlated has a very good chance of producing unstable recommendations that, wittingly or not, compound the effects of a number of weaknesses in the underlying models. In contrast, using broadly defined asset classes with lower correlations results in recommendations that remain constant despite small changes in estimated risk and return, and in so doing help to offset the uncertainties in the underlying asset allocation model.