Ferri: Asset Classes Vs. Investment Strategy

Ferri: Asset Classes Vs. Investment Strategy

It may seem like a mind bender, but owning different slivers of the same asset class can mean pursuing a different strategy.

Reviewed by: Richard Ferri
Edited by: Richard Ferri

Asset classes and investment strategies are two different concepts. An asset class is a category of tangible or intangible assets whose scope may or may not be fully quantifiable. The quantifiable part is the raw material from which an investment strategy is created. US equity is an asset class that’s fairly easy to define and measure. How one invests in US equity is an investment strategy, and there are many ways.

Each index provider has their own strategy for defining the US equity asset classes. This is by design. Index providers use different rules for inclusion, exclusion, rebalancing and reconstitution so they can be different. The CRSP US Total Stock Market Index has a slightly different return than the Wilshire 5000, the S&P Dow Jones US Total Market Index and the MSCI US Broad Market Index. Which one is the market? You decide.

Index providers also differ widely in how they divide their composite indexes vertically and horizontally by size, style, industry, geographic location, riskiness, and other methods of segregation. Differences in strategy lead to differences in return. These variations are not considered separate asset classes—the asset class remains US equity.

Strategy within an asset class also extends to how securities are weighted in a portfolio. The constituents in a U.S. stock market index may be full-capitalization weight, free-float capitalization weight, constrained, equal weighted, fundamentally weighted, etc. Each is a variation in investment strategy and generates a different return.

The index strategies you choose to represent asset classes in an asset allocation can have a meaningful effect on the outcome of the model. The differences are de minimis with U.S. total market indices, but they could have a major impact when indices are sliced and diced into categories where index providers have larger differences in strategy.

Commodities are probably the easiest way to illustrate the difference between asset class and strategy. It’s generally agreed that commodities include agricultural products (grains, food and fiber), livestock and meat, energy products, precious metals and industrial metals. Yet, there is no agreed upon way to measure the commodities market as an asset class. Commodity indices are primarily investment strategies that employ radically different weighting and rebalancing schemes. The figure below  illustrates the difference in weighting methodologies for some commodity index providers.

Weighting of commodity types from various index providers



Source: Chart by Rick Ferri; data by Morningstar

The difference in weighting methodologies creates wide dispersion in annualized risk and return among commodities indices. This makes asset allocation difficult, and it places a burden on investors to pick the right index strategy for the times. See Beyond Beta—Passive Alternatives to Active Commodities Strategies for an in-depth analysis on this subject.

Indexes are not asset classes, although many total market indices do represent them fairly well. Depending on the asset class, an asset allocation model can be affected by an index provider’s strategy. Knowing the strategy behind an index and being comfortable with it goes a long way to ensuring your portfolio tracks as closely as feasible the risks you’re seeking.

For a full list of relevant disclosures, click here.

Rick Ferri, founder of Michigan-based Portfolio Solutions, is a widely recognized index investor and the author of several books on index investing.

Attend Inside ETFs, the World's Largest ETF Conference!

Richard Ferri, CFA, is founder and managing partner of Portfolio Solutions. He directs the firm's research and education, and is head of the Investment Committee. Ferri writes regularly for the Wall Street Journal, Forbes, the Journal of Financial Planning and his own blog at www.RickFerri.com.