Focus K i T C E S

What Makes Something anAlternative Asset Class, Anyway?by Michael E. Kitces, CFP, CLU, ChFC, RHU, REBC

The most typical definition of inasset class is a group of securitiesthat have similar risk/returncharacteristics and behave similarly inthe marketplace. Thus, for instance,stocks, bonds, and cash represent thethree most common asset clcisses, aseach has different risk/return charac-teristics and behaves very differentlyin response to various economic andmarket events.

One of the most common ways todetermine whether an investmentrepresents a unique asset class is toexamine its correlation with otherinvestments. After all, two invest-ments that have different risk/returncharacteristics and behave differentlyin response to market events wouldlikely show little similarity in returnsover time, thereby exhibiting a lowcorrelation. Given how modernportfolio theory demonstrates thatinvestments with a low correla-tion to the rest of the portfolio canlower the overall volatility of theportfolioeven if the underlyinginvestment itself is volatileadvisershave increasingly sought out low cor-relation "alternative" asset classes andinvestments to manage risk throughdiversification.

The caveat, however, is that in anincreasingly complex financicil world,having a low correlation cJone canactually be a remarkably poor andmisleading indicator of what constitutesan alternative asset class.

Instability of CorrelationsOne of the primary problems with usingcorrelation as a measure to determinewhat may be an alternative or differentasset class is the fact that correlationsthemselves are often unstable. Forinstance, as many advisers noticed inlate 2008, many asset classes that werepreviously low correlation actuallyhad a very high correlation during themarket decline. The end result, at leastin retrospect, was that a number of assetclasses were actually low correlation tostocks during the bull markets but highcorrelation during bear marketswhichmeans they were a drag on returns whenmarkets were up, yet provided littlediversification value when needed. Thereason? Because in the end, the assetclasses were still subject to the sameunderlying risk factors; and when thosefactors, including an economic reces-sion and a contraction of credit, actuallydid occur, many asset clcisses previouslythought to be separate moved in sync.The bottom line is that a low correlationonly matters if it's expected to be lowwhen it's needed, not just on average.

It's also important that the correlationbe genuinely low in the first place. Ina world where correlations have crepthigher across many asset classes overthe past several decades, so too has thethreshold for what a "low" correlationrecJly is. While at one time correlationshad to be 0.2-0.4 to be considered"relatively low," many advisers now view0.5-0.7 as being fairly low ... despite the

fact that in the end, such correlationswouldn't have been truly expected toproduce much diversification even withtraditional portfolio design.

Low Correlations Through Active ManagementAnother confounding factor to usingcorrelation as a means of determiningwhether something is an asset classis the fact that some investments areactively managed, which leads to thepossibility that low correlations maysimply be a result of the varying deci-sions of the investment manager, not adifference in the underlying chciracteris-tics of the investment.

Historically, this hasn't necessarilybeen an issue; "actively managedequities" has never been viewed as adifferent asset class than equities, butsimply represents the opportunity forthe manager to add (or subtract) alpha,on top ofthe underlying returns of theasset class itself. However, in today'senvironment vsth an increcising numberof "go-anywhere" investment managers,the situation is less clear. An investmentmanager who was in cash in 2008 andequities in 2009 would show a veryfavorable return, but would exhibita relatively low correlation to cash(because half the time was in equities)and a relatively low correlation to equi-ties (because half the time was in cash).

If the fund was simply a balancedfund that maintained a 50/50 exposureto stocks and bonds, it would berelatively straightforward to see that the

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K l J C E S Focus

fund represents not a new asset class,but simply a 50/50 exposure of twounderlying asset classes. However, thereality is that when the mzmager chooseshow much or whether to invest in eachunderlying asset class, and shifts overtime, the correlations may decline butthe asset class of the fund itself hasn'tchangedjust the allocations. As aresult, it arguably may be more efifectiveto evaluate such funds relative to theasset class of their benchmarkwhatthey intended to mimic or track beforeadding or subtracting alpharatherthan what the manager (temporarily)holds. After all, if a fund's goal is to beatthe equities asset class, which it does byholding equities except when they arerisky and overvalued Emd cash repre-sents a better investment opportunity,does the asset class of the fund changethe day it shifts to cash, or just its short-term allocation?

Trying to Determine an AiternativeAsset CiassSo how should a planner determinewhether an investment constitutes aunique asset class or not, especiallygiven the rising populcirity of "alterna-tive" asset classes?

The key is a return to the originaldefinition of an asset class: a group ofinvestments that shcures common risk/return characteristics and behavessimilarly in response to economicand market events. If an investmentmeets these criteria, then it should alsohave a low correlation to other assetclasses. However, as shown earlier, alow correlation jJone is not a sufficientcriterion for determining an asset class,as there are many factors that can resultin a low correlation that have little to dowith what defines an asset class (and/ormay not represent a distinct asset classat the time it's needed!).

When we look to the underlyinginvestment characteristics, some assetclasses meet the test far more effectively

than others. For instance, real estate andcommodities have unique characteris-tics, are driven by economic and marketfundamentals that are different fromother traditional asset classes, and whilethey happened to move in sync duringthe 2008 financial crisis, they clearlywould not have a high correlation in alleconomic environments. For instance,while stocks, real estate, and com-modities may move in lockstep duringa deflationary environment (whilegovernment bonds go the other way),a rising inflationary environment cansend commodities soaring while stocks,bonds, and real estate take a hit (atleast, until their prices/rents can adjustand generate higher revenues). Realestate may also be sensitive to interestrates, which affects the capitalizationrate that affects real estate prices, in amanner that is similar to bonds but verydifferent from how interest rates affectcommodities or equities.

On the other hand, in somesituations the lines are less clear. Largecapitalization stocks are often viewedas a separate asset class from smallercapitalization stocks, even thoughboth will typically rise in a growthenvironment and decline in a recession(at least, unless there are significant dif-ferences in valuation). Similarly, thereis much debate about whether sectorsof the economysuch as utilities versustechnology stocksconstitute separateasset classes or not. While they are bothequities, the reality is that their correla-tions may be lower and their returnsmay actually diverge more through aneconomic cycle than large- versus small-cap stocks; technology stocks oftenrise and fall with the economy, whileutilities typically move in a "counter-cyclical" fashion.

An especially problematic scenario forevaluating asset clcisses is the emergenceof many "hedge fund strategies" fundsand managed futures investment offer-ings, that often mix together multiple

asset classes to begin with, along withshifting allocations over time, to gener-ate low correlations to traditional assetclasses. Yet if actively trading equities isnot a separate asset class than equitiesin general, does that mean actively trad-ing commodities is not a separate assetclass from commodities, in the case ofmany managed futures funds? If thefund shifts between commodities, stock,and interest rate futures, does thatconstitute a new asset class, or simply acombination of the underlying, existingcisset classes? If the goal of a mergerarbitrage fund is to generate returns inexcess of cash while neutralizing marketrisk, even though the underlying invest-ments are equities, does that mean it's astock asset class, a cash asset class, or anentirely separate asset class? What aboutother active hedge fund strategies?

What do you think? Do you considerlarge-cap stocks a different asset classthan small-cap stocks? What aboututilities versus technology stocks? Aremanaged futures and hedge fund strate-gies a new alternative asset class, orjust the active trading of the underlyingasset clcisses? What makes something anasset class? Is it just a low correlation, ordoes it require something more?

FPA members can discuss theseand other questions with yourcolleagues on the "All Member OpenForum" community on FPA Connect,at Connect.FPAnet.org.

Michael E. Kitces, CFP, CLU, ChFC, RHU, REBC,

is a partner and the director of research at PinnacleAdvisory Group, a private wealth management/irm

in Columbia, Maryland. He is the publisher o/The

Kitces Report and the blog Nerd's Eye View through

his website www.JCitccs.com, and practitioner editor

for the Journal of Financial Planning. Follow him onTwitter at (SMichaelKitces.

www.FPAnet.org/Journal September 2012 I JOURNAL OF FINANCIAL PLANNING 23

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