1.3 Selection of Asset Classes

1.3.1   Criteria for Specifying Asset Classes

1. Homogeneity – A class should contain assets that have similar description and characteristics such as risk and return. Holding various assets in a class should not produce diversification.
2. Diversity – A classes should be less correlated to other classes. A high correlation between classes indicates that the classes are related in terms of risk and return characteristics, lacking diversification.
3. Mutual exclusivity – Individual assets should be clearly defined within a single classification. It should be possible to place an asset in one and only one class.
4. Collectively exhaustive – Taken together all asset classes should take into account (define) – as much as possible – all possible global investable assets. This not only increases the set of investable assets, but also pushes up the efficient frontier (increases return at all levels of risk).
5. Liquidity – An asset class should contain sufficient percentage of liquid assets. Liquidity ensures minimal market impact and transaction costs, thus enabling managers to rebalance portfolio in case of variance from strategic allocation.

1.3.2   Inclusion of International Asset Classes (Developed & Emerging)

There are a number of factors to consider in deciding whether to include a certain asset class into your portfolio:

1. The new asset class’ improvement on portfolio risk and return. Consider the asset classes’ effect on overall portfolio risk and return – asset class return, stand – alone risk and correlation with other portfolio assets. To determine this, Sharpe ratio if used.

Consider inclusion if: [E(R_new) – R_f]/∂_new > {[E(R_p) – R_f]/ ∂_p} ^ρ_Rnew,Rp

_{That is, Sharpe ratio of the new class should be greater than that of the existing portfolio multiplied by the correlation between returns of the existing portfolio and those for the new asset class.}

ii. Other issues to take into account include asset classes’ liquidity, legal, tax, political, currency and other factors that vary by asset classes.

iii. The asset classes must exhibit characteristic of distinct asset classes and provide benefits warranting inclusion in the asset allocation process.

iv. Client’s Investment Policy Statement (IPS) – inclusion of an asset class must take into account specific client’s objectives and constraints.