Practical analysis for investment professionals
30 December 2019

What Is an Asset Class?

Today, diversification and alternative returns are our top portfolio concerns. Why? Because low interest rates may have driven valuations of stocks, bonds, and other asset classes to unsustainable heights, so we’re forever on the lookout for uncorrelated assets to incorporate into our portfolios.

And of course, product providers are all too happy to accommodate us, touting everything under the sun as a new asset class that can diversify our risk.

But let’s take a step back and consider what an asset class is in the first place.

Subscribe Button

There is no universally accepted definition. Some describe it as a financial asset with certain cash flows. But then commodities wouldn’t qualify. So maybe an asset class has to pay a risk premium. But then cash and money market investments wouldn’t count either.

Here’s the definition I’ve been using:

An asset class is a group of assets with similar exposure to the fundamental drivers of the economy.

The problem with this interpretation, of course, is that it simply shifts the question one level up. It’s like saying that life didn’t start on Earth but was brought here by aliens. But how did alien life start, then?

So, the ultimate question is, What are the economy’s fundamental drivers, and how do they influence different asset classes?

The economy has many drivers, but only a handful really make a difference. Those are:

  • Growth
  • Inflation
  • Human ingenuity
  • Labor
  • Land
  • Resources and infrastructure
  • Greed

Some of these — growth, inflation, and human labor — are self-explanatory. Others require a bit more context.

What I mean by greed is the human desire to want more of everything, money in particular. The urge to create more wealth out of existing capital is at the heart of the entire financial industry. A bank lends money to corporations and private households to earn interest. Hence, all credit-related assets, whether corporate and high-yield bonds or mortgages, are exposed to our collective tendency not to be satisfied with what we already have. Hence, the credit cycle — essentially a cycle of greed and fear — is an expression of our fundamental human nature.

Human ingenuity — our drive to make things better over time — is another key contributor. Economists often use productivity as a catchall, but human ingenuity speaks to what is innate in us: We ask questions and seek answers. This propels productivity growth as we strive to solve our problems and build a future that is better than the past.

Of course, a society can hardly function without the space to feed, house, and employ itself. Hence, land — and its location — is a critical component of the economy.

But land isn’t the only input factor the economy requires. It also needs raw materials, most of which are still derived from natural resources, both renewable and non-renewable. And infrastructure is necessary to transport those raw materials to the production centers and on to the end consumer. These input factors are distinct from land because they are not as finite. New input factors can be created by, say, opening a mine or constructing a road. But new land is not so easily built from scratch.

My list leaves out the real interest rate, among other factors, that some may consider fundamental. But real interest rates are effectively set in reaction to growth and inflation expectations as well as other criteria, so it doesn’t quite qualify.

Financial Analysts Journal Latest Issue Graphic

Mapping the Asset Classes and Their Fundamental Drivers

Based on the above analysis, every asset class can be mapped according to its exposure to these various drivers. Stocks, for example, are driven mostly by economic growth and human ingenuity. Yes, inflation and other factors have an influence, but stock returns are primarily a function of the economy’s rate of overall growth and how well entrepreneurs and businesses increase productivity and develop new products and services that people want.

Government bonds are driven by the inverse of growth — slower growth, meaning higher bond returns through declining real rates — and inflation. And where there’s credit exposure, there is greed. After all, why else would we bother with corporate or high-yield bonds instead of safe government-backed Treasuries?

Private equity’s main driver is economic growth. With venture capital, human ingenuity is the main one. Leveraged buyouts are principally about greed since their higher returns are fueled by the use of debt.

And what about hedge funds? To me, they don’t constitute an asset class on their own but are rather a composite of the various asset classes in which they invest. They’re a form of active management that seeks to generate more return for a given level of risk than could otherwise be achieved with passive investments. They are driven by greed.

The following chart maps the different asset classes to their various fundamental drivers.

Asset Classes and Their Fundamental Drivers


What It All Means

All of this reveals something both important and obvious: We don’t need many different asset classes in our portfolios.

The deluge of “alternative” assets are mostly a rehash of exposures to these various fundamental drivers.

So the next time someone comes along promoting the benefits of, say, aircraft leasing as an asset class, we can refer to the chart and see that this “asset” is simply an expression of greed: It’s a credit instrument with a touch of economic growth exposure thrown in. Which, if we already have stocks and high-yield exposure in our portfolio, won’t add much in the way of diversification benefits.

Many alternative asset classes aren’t truly different. This tends to become glaringly obvious when a crisis hits and all the “uncorrelated” alternative assets suddenly nosedive in tandem with stocks. So why not avoid such a painful realization?

After all, all markets do is focus on the exposure to these fundamental drivers and their expected future development. So by breaking down what our assets are exposed to, we can anticipate how they’ll react in a crisis.





Professional Learning for CFA Institute Members


About the Author(s)
Joachim Klement, CFA


7 thoughts on “What Is an Asset Class?”

  1. Abhishek says:

    Precisely explained!

  2. David says:

    Hi Joachim, very nice literature. I only would like more insight to how greed made the list of drivers. I totally agree with the use of “Ingenuity” as a driver. But can it be said that the desire for efficiency drives greed itself? Take for instance, a brand new car model powered by water as a result of new device built into the car that can convert water to energy efficiently. Because Chemistry classifies water as a different and weak solvent, nobody gives the new corporation the benefit of doubt. Then a high risk taking financier decides to take chance and it becomes a success story. Though the financier cornered higher returns but the world is better off with new vehicle. More people might be able to afford the new brand of vehicle and a major input to driving the car around, fuel, now replaced with an abundant resource, water. Pollution and climate issues would be addressed. Just trying to reconcile the definition of greed with the desire for efficient productivity. Your insight would be appreciated. Tanks. David

  3. Shankar Muthukrishnan says:

    Hi Joachim, Concise Philosophy at its best. Thanks for this. The only point that I found missing was the sustainable investing element. Although, one could call out Growth achieved through sustainable practices as a manifestation of Human ingenuity, I would like to call this a separate Asset Class.

  4. Richard Chauvin says:

    I cannot reconcile your inclusion of greed while omitting fear. Those with income insecurity or food insecurity might be driven more by fear than greed. Instead of greed, which assumes you know the motivations of everyone, I would use productivity as a driver, though you might argue it is too aligned with human ingenuity to be added to your list. However, human ingenuity does not have to result in productivity improvement. Humans strive to leverage their time, ingenuity, resources to maximize the value produced by their work. If you take population growth as a constant, productivity is the primary driver of growth.

  5. Fascinating significance to the dynamics of a new decade .

  6. Sure greed for interest can come from dissatisfaction and can cause financial tunnel vision, wherein modern capitalistic financial practices, with all their jargon and intricate dynamics, become top priority, consequently taking away from the creativity that comes from the built-in human need for innovation and reinvention, and thus impeding growth at a point where money making becomes all consuming. When the opportunity of cost becomes a tool for creating financial anxiety, the soundest financial advice would be to evaluate the cost of this perpetual cycle of unnecessary anxiety over financial satisfaction. But as it stands, this anxiety is necessary in purely capitalist economies. It’s ingrained, futile but dangerous. People choose to ignore this then act completely shocked when someone like Blythe Masters reaches for the cookies. It’s easier to call out on the ethics of an individual than an economic way of thought.

  7. Very neat article…..As an analyst/financial planner who does a lot with insurance, estate planning and the sort, it’s a neat thought experiment to think about insurance as an asset class.

    Would greed, or more so risk aversion, drive human capital hedges like disability, critical illness, or life insurance…..

    Would greed, or loss aversion (since tis cheaper, especially in a private corp context, at least in Canada) be the reason to use permanent life insurance to cover estate tax…..

    Neat thoughts and great article!

Leave a Reply
