A Practitioner's Guide to Asset Allocation

CHAPTER 1What Is an Asset Class?

Investors have access to a vast array of assets with which to form portfolios, ranging from individual securities to broadly diversified funds. The first order of business is to organize this massive opportunity set into a manageable set of choices. If investors stratify their opportunity set at too granular a level, they will struggle to process the mass of information required to make informed decisions. If, instead, they stratify their opportunity set at a level that is too coarse, they will be unable to diversify risk efficiently. Asset classes serve to balance this trade‐off between unwieldy granularity and inefficient aggregation.

In light of this trade‐off and other considerations, we propose the following definition of an asset class.

An asset class is a stable aggregation of investable units that is internally homogeneous and externally heterogeneous, that when added to a portfolio raises its expected utility without benefit of selection skill, and which can be accessed cost effectively in size.

This definition captures seven essential characteristics of an asset class. Let's consider each one in detail.

STABLE AGGREGATION

The composition of an asset class should be relatively stable. Otherwise, it would require continual monitoring and analysis to ascertain its appropriate composition, and it would demand frequent rebalancing to maintain the appropriate composition. Both efforts could be prohibitively expensive.

Asset classes whose ...