Asset class investing is an important alternative to the methods that have been considered standard investment procedure for generations. As its name implies, asset class investing distributes capital across distinct groups, or classes, of securities, rather than picking specific stocks or industry sectors.
This article explores the fundamentals of asset class investing and what it means to investors.
What is an asset class?
The most useful definition of asset class is a set of securities 1) with similar risk and return characteristics that 2) tend to move as a group in response to economic and market conditions.
Stocks, bonds, and cash are the broadest asset classes. These categories meet the above definition in that any given stock behaves, in general, more like other stocks than like bonds or cash. Compared to bonds and cash, stocks tend to deliver higher returns over time, with higher risk. And stock prices, as a group, generally move in the same direction. Likewise, bonds act like bonds, and cash investments behave like cash investments.
A high level asset allocation might be 60 percent stocks, 30 percent bonds, and 10 percent cash. But in building portfolios, these classes, especially stocks, can be broken down into more specific categories. For example, large cap US stocks (such as those in the S&P 500) display different risk and return profiles than the stocks of small international companies. They may move in different directions or at different speeds in response to some economic, market, or political events. Therefore, they can be separated into distinct asset classes.
Asset class investors utilize these differences to intentionally shape the overall expected risk and return levels of their portfolios. That’s asset allocation in a nutshell.
Asset classes drive returns
Landmark academic research indicates that asset allocation explains more than 90% of portfolio return, far more than any other factor (Brinson, Hood and Beebower, 1991; Ibbotson and Kaplan, 2001).
These are critical findings for anyone creating and managing a portfolio. Consider this example: A thousand investors and/or money managers create unique portfolios by selecting a diversified mix of securities. The research indicates that – regardless of how they might have picked the securities, or the timing of any buying and selling thereafter – more than 90 percent of the risk and return they ultimately experience over time will be driven by the respective asset classes of their investments.
For instance, the fact that investor #200 holds thirty percent of his assets in large US growth stocks while investor #205 holds only five percent in that class will typically have a far greater influence on their overall returns than the choices they might have made between Google and Motorola, the timing of their trades, or attempts to improve performance by shifting from sector to sector as economic conditions changed.
What makes asset classes different?
The Brinson and Ibbotson studies demonstrate that it is asset allocation that dictates the vast majority of portfolio performance, even if the investor knows nothing about asset classes and makes no deliberate distributions to different asset classes.
But exactly what is it about the different asset classes that has such a dramatic impact on returns? Professors Eugene Fama of University of Chicago and Kenneth French of Dartmouth isolated three risk variables i that largely determine returns:
- Equities vs. bonds: Stocks have higher expected returns and more risk than bonds.
- Small vs. large: Small company stocks have higher expected returns and more risk than larger company stocks.
- Value vs. growth: Value stocks (low price relative to book value) have higher expected returns and more risk than growth stocks (higher price relative to book value).
Therefore, varying the allocation of funds across different asset classes affects the exposure to these three variables and yields portfolios with different overall risk/return profiles. For instance, a portfolio with more small company stocks will have a higher expected return and greater risk than a portfolio with more large company stocks, all other things being equal.
Asset class investing ensures that allocations to asset classes are intentional and controlled, not accidental.
How asset class investing gets done
A variety of investment vehicles can be used to implement asset class investing. Institutional style mutual funds specifically designed for their asset class characteristics simplify the task, but an asset class portfolio can also be constructed of index funds, exchange traded funds, and other vehicles.
The key requirement is that the manager of the portfolio can accurately determine and control the true distribution of all assets in the portfolio at all times. For instance, a mutual fund that includes a mix of large and small or value and growth stocks may limit the ability to fine-tune a portfolio’s asset allocation, and the allocation may inadvertently change if the fund’s style drifts, or the manager changes. And it is important to look under the hood; a fund that calls itself a small value stock fund can hold stocks from other classes, thereby skewing allocations.
Cost control
One important advantage of asset class investing is the ability to undertake it at relatively low costs. As the goal in asset class investing is to control risk and return through asset allocation – not stock picking or market timing – far fewer trades are typically required, which holds down transaction costs. Likewise, the higher management fees often charged by active fund managers can often be avoided. Controlling expenses is an essential element in protecting the long-term results of any portfolio.
Still the exception
Asset class investing is still the exception to the rule. The vast majority of investors and advisors continue to seek the elusive goal of beating the market through active management – in 2007, actively managed mutual funds held $7 trillion in assets, compared to less than $1.4 in index mutual funds and ETFs. ii But the tide may be slowly turning. Approximately 45% of net inflows in 2007 went to index funds and ETFs, and only 55% to active funds. iii
New asset class investors can be drawn to it not only because of the difficulty of outsmarting efficient markets, but also because asset class investing intentionally focuses on the key variables that determine expected risk and return. With its long-term, low turnover approach, asset class investing allows investors to ignore the daily financial news and focus on personal, family, and business interests.
i Eugene F. Fama & Kenneth R. French, “The Cross Section of Expected Returns,” Journal of Finance 47, no. 2 (June 1992): 427-65.
ii Financial Research Corporation, 2008
iii Financial Research Corporation, 2008
Reprinted with permission from Bright Sky Group, LLC. Bright Sky Group, LLC is not a registered investment adviser. The views expressed by Bright Sky Group represent the opinions of members of Bright Sky Group, but do not should not be construed as financial or investment advice. Further, the views are subject to change and are not intended as a forecast or guarantee of future results. The material provided by Bright Sky Group is for informational purposes only. Statements of future expectations, estimates or projections, and other forward looking statements are based on available information deemed reliable, but the accuracy of such information cannot be guaranteed. Statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results.
Kraft Asset Management, LLC, headquartered in Nashville, TN, provides prudent investment planning and wealth management services. Kraft Asset Management, an affiliate of KraftCPAs, is a founding member of the Bright Sky Group.
