False diversification and the rise of novel asset classes

24Oct08

One of the many disappointments of the current crisis has been the utter failure of diversification to shield investors from harm.  Absent an investment in plain vanilla Treasuries every asset class has seen historically poor performance.  While every one would agree these are unique times that does not erase the losses that have already occurred.

The rise of so-called novel asset classes has lead some investors to diversify their portfolios with investments that are not novel at all.  They simply constitute the incorporation of a narrow industry sector or strategy into an ETF form.  This false diversification lead some investors to feel that their portfolios were less risky than they actually were.

We touched on this problem a long-time ago in a post entitled:  What defines an asset class? At the time it was becoming clear that the ETF industry was going to slice and dice the investment universe in search of additional product.  Most of these novel strategies that looked so good in backtest form have not held up in the current market environment.

This is all in order to note an important post over at All About Alpha on why hedge funds are not an asset class.  In it they cite eight criteria from Alan Dorsey on what is a true asset class.  A quick taste:

The first is that it must have an “intrinsic value“.  In other words it must provide a return that is not “speculative” and must have an “implicit rate of return”.

Hedge funds are an aggregation of all manner of investment strategies.  Trying to mold a coherent case for them as an asset class is difficult at best.

The challenge for investors still seeking diversification is in trying to substantiate what constitutes a truly novel asset class, and what is in actuality simply a sector fund or investment strategy masquerading as an asset class.  The last few years have blurred those lines.  Unfortunately many investors are paying the price for that now.

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3 Responses to “False diversification and the rise of novel asset classes”

  1. GREAT POST!!!

    Used to drive me nuts that people would describe hedge funds or private equity as an asset class. Well private equity is still EQUITY. You’re making money off of the profits of a business. And hedge funds are really nothing more than a savvy manager trading an asset class — whether it’s currencies, commodities, real estate loans, or stocks. It’s still the

    You could even go so far as to say that there is no such thing as an asset class. Take corporate bonds (fixed income) versus stocks (equity) — they’re still both dependent on the success of the business. Mortgage loans (fixed income) versus actual property (real estate) — they’re still dependent on the value of the property. You could even make the case that government bonds are also based on the ability of the government to collect taxes. If businesses collapse, the government loses an income stream, which makes the government bonds risky. While these supposedly different asset classes may behave differently most of the time, when chaos strikes, they revert back to what the underlying class is based upon, which is BUSINESS.

    I think a lot of people forget that most asset classes are all supported by the same thing.

    — Don

  2. 2 RM

    I’ve been following this thread of inquiry closely as I’ve been very intrigued about true diversification (esp in contrast to hedging) and true asset classes.

    This powerpoint has a useful summary of the criteria that Greer, Kritzman and Sweden use to identify asset classes
    http://www.cqa.org/uploads/papers/203644393646f2f901d6d9f.ppt

    I like the idea of diversification being more about the upside to capture a diversity of positive, long-run risk-premiums. In bear markets when risk appetites collapse, probably only hedges and risk-free assets can help.

    http://www.businessweek.com/magazine/content/08_43/b4105073900964.htm

    “Bodie: We teach students that you only need two mutual funds—the risky assets and the safe asset—to generate the entire set of risk-and-reward trade-offs.”

  3. Yes! And now we have people calling volatility an asset class :) It has been tough to find asset classes that don’t exhibit fairly high degrees of correlation. I wonder whether that’s because so many people are following a very simple asset allocation model. There’s a good website (http://www.assetcorrelation.com) which doesn’t adhere too strictly to the exact definition of asset classes but is a very useful tool to analyze correlation within a portfolio.


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