Boxes Are Not Classes

In the September 2005 Investment Advisor, we showed that investing constrained by characteristics (value-growth and market capitalization) costs investors almost 300 basis points per year in performance. Requiring managers to hold stocks that are limited to certain value-growth and market capitalization characteristics hurts performance because all of the manager’s best stock selections do not necessarily fit into that assigned box.

In presenting these findings at various conferences, many advisors have nevertheless told us why they still think constraining managers is good for their clients. One of their arguments is the notion that by constraining managers to characteristic boxes, the investor or advisor is performing asset allocation. The foundation of that position is the incorrect belief that the various characteristic boxes are asset classes, and that a manager can therefore specialize in a particular asset class. This article, based on our white paper, available at www.athenainvest.com, will show that characteristic boxes are not asset classes, and that allocating among various characteristic boxes is useless at best.

Let’s begin by defining and describing an asset class. To be an asset class, a group of investments should meet three criteria:

Compositionally Unique. This means that an asset’s class should be clear and that different analysts should agree on its classification. It should be obvious to everyone in the market into which class a particular asset is placed. If this is not the case, then the definition of asset class depends on the person or organization performing the classification. Under that scenario, the asset class has little or no commonality across market participants and it would be very difficult to use it as a basis for constructing and managing portfolios. That’s because when an investor wishes to invest in the XYZ asset class, what that investor actually invests in depends on the person or the organization doing the classification.

Low Correlation. Asset allocation among stocks, bonds, real estate, commodities, and cash offers attractive risk/return tradeoffs because those five asset classes have returns that are low in correlation. If, instead, they were strongly correlated, there would be little diversification benefit and there would be just one optimal portfolio; the asset class with the highest return-to-risk ratio. With a strong positive correlation, these investments would just be a linear combination of each other. To rate the distinction of being an asset class and therefore to serve any diversification benefit, an asset’s returns must be low in correlation to other asset classes.

Stable Composition. Finally, the composition of membership of an asset class should be stable over time. Assets should not be changing class frequently, if at all, over time. As an example of this, imagine the case where bonds and stocks constantly moved into each other’s asset class. How useful, then, would the concept’s stocks and bonds be for managing money?

Our evidence shows that the characteristic boxes defined by value-growth and market capitalization fail all three criteria. It is clear that they are not asset classes and that allocating among them is not asset allocation.

We tested the characteristic boxes to see if they met the three criteria, and we found failure on each count.

Failure One: Not Compositionally Unique

Market observers can easily sort assets into the following categories; stocks, bonds, cash, real estate, and commodities. There is not much disagreement. Convertibility aside, stocks are stocks, bonds are bonds. With characteristic boxes, however, the opposite is true: There is tremendous disagreement between classification systems and even within each classification system.

Focusing on the size dimension, five of the best known information services–Morningstar, Morgan Stanley, Standard & Poor’s, Wilshire, and Russell–have very different definitions regarding market capitalization, as shown in the “Wide-Ranging Cap Ranges” chart (below). “Large cap” ranges anywhere from 67% to 92% of the total U.S. market capitalization. The services’ various definitions of “small cap” range from Morningstar’s 3% to Morgan Stanley’s 12% of U.S. market cap. In fact, Russell denies the existence of mid-cap as a separate asset class altogether, designating the smallest 25% (of total market cap) of their large-cap index as “mid cap.”

Focusing on Morningstar (as of 5/31/05) and S&P (as of 6/15/05), there were 1,301 stocks in common. While S&P agreed that every stock Morningstar had as large-cap belonged there, that’s where the agreement ends. Only half of the Morningstar mid-cap stocks were categorized that way by S&P, and a little less than 75% of Morningstar’s small-cap stocks were called small cap by S&P. Over all, there was slightly more than 30% disagreement between the two information services on how individual stocks should be categorized in these supposed “asset classes.”

We also performed a similar cross-service comparison for the value-growth dimension. S&P does not have a “core” category. Among the stocks not in the Morningstar core category, S&P and Morningstar disagree on 20% of the remaining value or growth stocks. That is a remarkably large area of disagreement for supposed “asset classes.”

Within each service, the break points for cap size are not crisp and distinct, and all the services display some overlap. Fully 50% of the Morningstar “mid-cap” stocks are smaller than the largest “small-cap” stocks in the S&P classification, and a little over 23% of the “large-cap” stocks are smaller than the largest “mid-cap” stocks in S&P.

This is not a case of who is right and who is wrong or which system is best. It is a case of characteristic boxes failing the first criteria for being asset classes. We assert that they are not compositionally unique, but rather are compositionally common or blurred. Therefore, they do not pass the first test of an asset class.