Traditionally, institutional investors thought of only two asset classes: debt and equity - defined as
investments which promise a regular income stream, and those which do not but are linked directly to
corporate profits. All else can be called “alternative”. The assumption behind this framework is that the vast bulk of possible investments fall into these two main asset classes. Investments whose classification are ambiguous are called alternative. Under this terminology the distinctive investments within alternatives are “strategies”.
This traditional framework is often seen as semantic, ignored by asset managers who care little where
they are allocated money from, and ignored by consultants who understand the important distinctions
between different strategies. The framework is used by for example pension fund staff to categorise
investments in an intelligible way to trustees and others. To some extent having a catch-all category may actually enable more diverse investments where non-expert trustees are making asset allocation decisions.
The evolution from this framework has been gradual. International components have been added to the debt and equity asset classes and the trend has been to separate these and call them new asset classes. But this in itself raises questions about the framework. If one admits to the usefulness of investing abroad this is presumably because of the different risk return profile compared to the domestic market.
But there is more than one abroad (more than one foreign country) and so why would the domestic market be separated from others? For investors in some domestic markets this may make more sense than others.
However, the case for separation may not be universally appropriate given the possibility of hedging out currency risks, the availability of portable alpha techniques to manage liabilities more separately from investments than in the past, and given the suspicion that efforts to match liabilities are largely ineffective if not completely fictitious anyway (see last month’s Emerging View: Rethinking Asset Allocation).
As the evolution continues so new asset classes have been discovered, separated from the alternatives
bucket in some cases, but in other cases included as mere subdivisions of it. Many different definitions of what is and what is not an asset class now exist and these differences do then impact asset allocation, both in the range of eligible strategies and the possible allocation sizes. The arbitrariness may be well understood, but the impact no less real for that. Classifications create and cement perceptions which in return drive behaviour and asset allocations.
The traditional framework with added asset classes tacked on can be defended as a largely benign
convenience insofar as there is, semantics apart, consensus about what constitute underlying appropriate investment strategies. However this consensus is elusive to many observers. Also, the framework appears to be crumbling at its equity/debt core on two counts.
First, bonds can be volatile and their providing a steady income flow is often little more than a convenient fiction (the convenience often being for accounting and regulatory reasons). As one moves to areas such as emerging markets, bonds often have equity type returns. There are simply more and more strategies which do not neatly fall into the traditional equity/debt division.
Second, the actual allocations of some investors, for example many foundations and endowments, has moved towards a 50% allocation to alternatives – so are they now the new core, and domestic debt and equity the new alternatives? Then we come to the perception of risk, which distorts rational asset allocation. As a prelude, risk is not the same as volatility and the difference between the two increases with the amount of information asymmetry in a market (low tracking error often signalling lack of expertise not the reverse). Second, just about all institutional investors are “conservative” and prefer less risk to more - these are therefore weak concepts.
Third, the world is not composed of risky and non-risky investments. Rather, all investments
are risky. Instead of asking whether something is risky an asset allocator should instead ask two
questions. First, is the risk priced in? (Generally emerging market sovereign risk is and developed market sovereign risk is not for instance.) Second, is it correlated to other risks in the whole portfolio? US Treasuries are not risk free, neither are they uncorrelated to other asset classes.
So what is the alternative to using alternatives? It is what a lot of investors already do. Instead of
maintaining large core domestic debt and equity allocations all strategies are considered as possible
allocations without a bias to domestic assets, combined with a more serious effort to match liabilities
using all the possible ways of doing this. This is different to just putting a lot of eggs in one basket
(however well woven) and sitting in domestic bonds. Likewise the pattern of shifting into domestic
bonds when domestic equities look over-priced (and back again later) does not constitute meaningful
asset liability management, whatever the intentions at the time.
Asset allocation is a process, taking time and effort to understand the full range of possibilities. Issues
such as market size, liquidity, but also growth prospects of strategies are important, but it is also vital to use accurate data not prejudices to establish these factors. At US$4.3tr the tradable emerging debt market is for example much larger than the FTSE100, and grew at 29.5% last year. However, not many European, let alone UK, pension funds have anything like the same size allocation (yet).