Traditional and Risk Based Approaches to Asset Classification

To effectively analyze a portfolio or potential investment opportunities, investors must establish a comprehensive and mutually exclusive categorization scheme, known as the ‘opportunity set.’ This is crucial to ensure that all investments are considered and prevent double-counting or missed opportunities. Two common approaches are:

• Liquidity-based approach.
• Performance expectation approach.

The liquidity-based approach typically starts by distinguishing between public and private investments, with private investments being less liquid. This approach further subdivides categories, as illustrated in the table below:

$$ \textbf{Major Asset Class Categories} \\
\small{\begin{array}{c|c|c|c}
& {\textbf{Equity &} } & {\textbf{Fixed Income &} } & \textbf{Real Estate} \\
& \textbf{Equity-Like} & \textbf{Fixed Income-Like} & \\ \hline
\textbf{Marketable/Liquid} & \text{Public Equity} & \text{Fixed Income} & \text{Public Real Estate} \\
& \text{Long/Short Equity} & \text{Cash} & \text{Commodities} \\
& \text{Hedge Funds} & & \\ \hline
\textbf{Private/Illiquid} & \text{Private Equity} & \text{Private Credit} & \text{Private Real Estate} \\
& & & \text{Private Real Estate} \\ \end{array} }$$

Investors can also categorize asset classes based on their expected behavior in different economic conditions:

1. Capital growth assets tend to rise in value during periods of economic growth. This category includes both public and private equities.
2. Inflation-hedging assets, such as real estate, commodities, natural resources, and inflation-linked bonds, are expected to perform well when inflation expectations increase or if inflation surpasses expectations.
3. Deflation-hedging assets, like nominal government bonds, may outperform most other asset classes during periods of slow economic growth and low inflation.

Main strengths of traditional approaches:

Easy to communicate

Traditional asset-class-based approaches are widely understood by investors, making communication and comprehension straightforward.

Relevance for liquidity management and operational considerations

These approaches are particularly useful for managing liquidity due to the significant differences in liquidity profiles between public and private asset classes.

Main limitations of traditional approaches:

Over-estimation of portfolio diversification

Investors might overestimate the level of diversification in their portfolio without a proper analytical framework.

Obscured primary drivers of risk

Different investments may be grouped together under the same asset class, potentially obscuring the primary drivers of risk. 

Risk-Based Approach

A more precise way to define investment opportunities is through a risk-based approach. This method categorizes investments based on their exposure to specific risk factors, making it less subjective and more quantitative. Risk factors often considered for alternative investments include:

• Equity market return: It reflects the overall trend of global equity markets and is often considered the most accurate market indicator for ‘growth’
• Size: The additional return of small-cap stocks compared to large-cap stocks.
• Value: The surplus return of value stocks compared to growth stocks (negative factor sensitivity indicates a preference for growth stocks).
• Liquidity: Refers to the Pastor-Stambaugh liquidity factor, a market-wide metric based on the disparity in returns between stocks that are highly responsive to changes in overall liquidity (less-liquid stocks) and stocks that are less affected by shifts in liquidity conditions (more-liquid stocks)
• Duration: Responsiveness to fluctuations in the 10-year government bond yield.
• Inflation: Reactivity to adjustments in 10-year breakeven inflation rates derived from the inflation-linked bond markets..
• Credit spread: Responsiveness to fluctuations in the high-yield spread.
• Currency: Responsiveness to fluctuations in the domestic currency in comparison to a collection of foreign currencies.