Asset Class Allocation - CFA, FRM, and Actuarial Exams Study Notes (2024)

Three Super Classes

An asset class is a group of assets that all share some common elements. Asset classes help organize investment portfolios into separate components. We can start with the broadest sense of the word and divide assets into “super classes”:

• Capital.
• Consumables.
• Store of value.

Capital Assets

Capital assets are anything that can be valued using a net present value framework. In other words, they produce a regular cash flow or ongoing value. Examples include:

• Equities.
• Fixed income.
• Interest-bearing notes.

Consumable/Transformable Assets

These resources do not provide a direct cash flow but act as an input in production. Examples include:

• Oil.
• Timber.
• Precious metals.

Store of Value

This final category is represented by assets that neither produce income nor can be transformed into finished goods for sale. Examples:

• Currency.
• Art.
• Collectibles.

The Five Distinct Characteristics

To properly define an asset class, modern financial theory suggests five imperative criteria:

1. Assets within an asset class should be relatively hom*ogeneous: Assets should be similar, or grouping them brings no value.
2. Asset classes should be mutually exclusive: One asset class needs to be clearly defined to the point at which any asset cannot belong to multiple groups.
3. Asset classes should be diversified: Investing across asset classes should bring exposure to diverse risks across the portfolio. This tends to come with meeting criteria #1 but is explicitly stated in criteria three from a risk perspective.
4. The asset classes as a group should make up a preponderance of world investable wealth: No asset should be left out. Every asset must have some class it can fall into, or else potential real-world portfolios would be un-analyzable from an asset allocation perspective.
5. Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor’s portfolio: The asset should be realistically purchasable for the investor and not so encumbered with transaction costs and liquidity risks that it becomes unviable.

Professional Practice Current Groupings

Practitioners entering the field will likely find the general subset of asset classes below. These have become popular in professional applications and have become so due to their usefulness. These four significant categories tend to satisfy the five requirements of an asset class listed previously:

• Global public equity: These represent an ownership stake in the cash flows of a stock that trades freely and openly on recognized exchanges, including the NASDAQ, FTSE, and NIKKEI.

• Global private equity: These represent an ownership stake in the cash flows of enterprises that do not fit the publicly-traded definition. Examples could include money invested in private equity ventures.

• Global fixed income: These comprise both developed and emerging market debt.

• Real assets: These represent physical assets such as investments in real estate, commodities, and private infrastructure.

The basic representations shown so far are comprehensive and overarching. Each set mentioned could be broken down further by country, industry, market capitalization, etc. It is important to remember that the more granular become less distinctive and, for this reason, perhaps less helpful. The analyst must always consider the trade-off between adding additional asset classes into their analysis and the resultant drop-off in hom*ogeneity.

Common Risk Factors

Another valuable lens through which analysts may parse their portfolios does not involve asset classes as they have been defined so far but using risk factors. Each investment in a portfolio would be viewed not by the asset class it belongs to but by what risk factors it is uniquely exposed to, including:

• Volatility.
• Currency.
• GDP growth.
• Value.
• Momentum.
• Liquidity.
• Inflation.
• Convexity.
• Duration.
• Default risk.

Each security would be assessed based on its various factor exposures and either added or removed from a portfolio based on the total exposure an investor wishes to have.

The benefit of using factors is that they tend to unhide shared risk factors between asset classes. The downside is that there is no ready-made template for each factor, when it will be present, and to what degree.

Question

Natural gas and preferred stock in Conoco Phillips would most correctly be classified as which of the following super-asset classes, respectively?

1. Consumable asset; Capital asset.
2. Capital asset; Store of value.
3. Store of value, Capital asset.

Solution

The correct answer is A:

Petroleum is a consumable/transformable asset. It can be consumed to generate power or provide fuel for transportation and manufacturing.

B is incorrect. Stocks are capital assets as they provide a stream of dividend income.

C is incorrect. A store of value is represented by assets that neither produce income nor can be transformed into finished goods for sale. Examples include coins and art.

Reading 4: Overview of Asset Allocation

Los 4 (f) Explain the use of risk factors in asset allocation and their relation to traditional asset class–based approaches

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