An asset class is a broad group of securities or financial instruments that conforms to the following criteria:
- All asset in the asset class should share similar return and risk profile
- An asset in the asset class can’t reasonably belong to multiple classes
- Assets within an asset class should be homogeneous.
- Assets should show similar behavior in the marketplace.
A concept such as Asset Classes seems pretty simple and straight forward and is easily thrown around in conversations. However, when you start to inspect something like the criteria above, you get into the weeds of it. You get to know the nuances of reality that hide behind an otherwise simple definition.
CFA definition of Asset Classes
The CFA Institute is a global association of investment professionals or Chartered Financial Analysts. The CFA Institute defines three main asset classes:
- Fixed income securities: Bonds and other loan agreements
- Equity securities: (stocks, both common and preferred)
- Alternative assets (basically everything else that does not fall into the classes above)
What are the main Asset Classes?
Naturally, you could go much deeper in your definition of assets classes. Private securities (both bonds and stocks) do not necessarily have the same risk or return profile as securities that are publicly traded. Securities listed in one country do not have the same risk profile as securities in other markets. Therefore, by diving deeper you will definitely identify Asset Sub-classes.
When you look at the Alternative Asset Classes, you will run into a problem of definition, as the assets within an asset class might overlap with other asset classes. Real Estate is by many considered to be on of the Alternative Asset Classes. But does that only apply to direct ownership of real estate? Surely, a real estate companies, stocks and bonds should belong to the main Assets Classes, right?
One way to look at what constitutes an Asset Class is that it has to be indexable and be able to provide a benchmark. An index of square foot prices of a specific type of real estate in a given market, say commercial real estate across the United States, will not provide will not correlate the performance of an index of the commercial Real Estate Investment Trusts in the U.S. Even though there is overlap, they are tracking almost entirely different things (transaction prices versus profits of owning and renting out the properties).
Are ETFs an Asset Class?
An ETF, or Exchange-Traded Fund, is a marketable security that aims to track a specific index or a basket of assets. Exchange-Traded Funds are entirely passively managed as they only track the index that they are meant to track through predetermined rules.
But if ETSs are a way to track the performance of an index or a basket of assets, can they constitute as an Asset Class? In other words, can something that mimics an asset class be an asset class in itself? ETFs are financial instrument different from stocks and bonds, but then what about other instruments, such as options, futures, forwards and warrants? Those instruments are derived from the main asset classes but are far from being homogeneous with stocks and bonds, with a totally different risk profile.
What Alternative Asset Classes are there?
An asset class is a broad group of securities or financial instruments. Where does that leave commodities or currencies? Crude oil, green lumber, wheat, pork bellies and even orange juice are commodities that are actively traded on exchanges. But are they an asset class? A pork belly or a barrel of orange juice is neither a security nor a financial instrument. What exactly is being traded on commodity exchanges?
The Minneapolis Grain Exchanges trades Red Wheat, National Corn and National Soybeans. But the instruments that are being bought and sold on the exchange are not the commodities themselves, but futures and option contracts. What about gold? Gold is generally considered an asset class, but in order to invest in gold you can buy the physical commodity, futures and forwards. You can also buy stock in gold miners or even companies that fund gold miners through royalty contracts. Yet, these instruments are far from being homogeneous, having the similar risk profiles or behaving similarly in the market.
What about commodities where there exists a market where they are traded. The transaction prices can be benchmarked and the underlying assets are homogeneous, albeit without the derived financial instruments. Is that an Asset Class? Consider for example the Icelandic Horse, which is a breed of small sized horse that was originally breaded in Iceland.
The horses are bought and sold. There exists horse farms that earn a living through farming the Icelandic Horse. There even exists an international market for the breed. The lineage of each stud is carefully recorded and besides trading in horses, you can buy sperm from specific studs. If this has not already been done, one could with relative easy compose an index of the spot market value of the sperm of various studs of reputable lineage. Does that mean that the Icelandic Horse constitutes as an Asset Class category, even though these does not exists a liquid futures market for Icelandic Horse Sperm (pun intended)?
Is Crypto-currency an Asset Class?
A crypto-currency such as Bitcoin is about as much a financial instrument as it could be. It is fact a financial instrument without any underlying assets. The general conception is that a commodity such as gold can have utility through its scarcity value.
If you would be able to collect all the gold in the world and melt it into a cube, it would essentially fit into two tennis courts, side by side. Because of the limited supply of gold, the relative easy to measure and easiness to transact with, it has served as a store of value for centuries. But, although the two latter qualities where very important at some point in time, most of the modern day trading in gold is done by a variety of derivative financial instruments to which gold is the underlying asset.
So, if it is only a matter of the scarcity value, do you really need an underlying asset if you can create a financial instrument with inherent scarcity programmed into it? This is essentially what Bitcoin is, a financial store-of-value instrument without the underlying asset. Only 21 million Bitcoins will be mined into existence. After that, no more will be produced, hence the ultimate supply is fixed. But even though Bitcoin is structured in that way, other crypto-currencies have totally different characteristics that are in no way homogeneous with Bitcoin. Does that mean that crypto-currencies are or are not an Asset Class? Perhaps time will tell.
The Purpose of an Asset Class
When somebody tells you that now is a good time to invest in gold, bonds, stocks or any other class that constitutes as a basket of similar assets, the advice is essentially meaningless without further detail.
Forces such as new financial instruments, globalization of corporations and innovations in financial instruments have in some way blurred the meaning of Asset Classes. Investing in gold as an asset class can mean investing in instruments that behave in a very uncorrelated ways (think gold miner versus the spot price of gold), investing in real estate mean investing in stocks and bonds and investing in ETFs tracking country specific stock markets can mean exposing you to markets in other other countries.
As so often is the case, the devil lies in the details.