What defines an asset class?


The term "asset class" is thrown around today with little regard as to what it actually means. We found a good definition over at Investopedia:

A specific category of assets or investments, such as stocks, bonds, cash, international securities and real estate. Assets within the same class generally exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.

If we take this as good definition of an asset class what are we to make of this quote from a piece by Lawrence Carrel at SmartMoney.com?

"Putting together an IPO ETF confirms that this is a separate asset class which is less correlated to the big indexes and offers the potential for more unique returns," says Kathleen Smith, a principal at Renaissance Capital, an independent research and money-management firm in Greenwich, Conn. Renaissance runs an actively managed IPO mutual fund, the IPO Plus Aftermarket Fund (IPOSX).

So let's get this straight. The act of forming an ETF confirms asset class status? A simple example will show that this claim is unsupportable, and is based more on marketing than on sound financial theory.

Another ETF, the Rydex S&P Equal Weight Fund (RSP) invests in the same stocks as those found in the good old fashioned Standard & Poor's 500 (SPY) but using a different weighting scheme. Rather than using capitalization weights the fund equally weights the holdings. The fund has also has a lower average market capitalization than the S&P 500, and also generates "unique" returns.

However nobody, including Rydex, claims that the RSP is a separate and unique asset class. It clearly is another example of an equity fund. Stocks that recently had an initial public offering are a subset of the greater equity asset class. Just as all stocks with a symbol starting with the letter 'M' are a subset as well. However nobody claims any special status to the 'M' stocks.

The First Trust IPOX-100 Index Fund (FPX) may very turn out to be a great investment, or a complete dud. We frankly do not have an inkling as to which will be the case. The bottom line is it is an equity fund. Nothing more, nothing less. Its returns will be driven by the performance of the stocks therein. However trying to confer some sort of special "asset class status" for the fund is self-serving and not supported by logic or the evidence.

2 Responses to “What defines an asset class?”

  1. 1 Roger Nusbaum

    For what its worth I think there can be value in looking at these types of funds for what they can serve as a proxy for. The track record for the underlying index shows a reasonable correlation to small cap growth as measured by IWO but it has consistently outperformed IWO. Does this mean anything for the future? Who can say?

    Google is 10% of the fund which is the limit for any one stock. 10% in one name is not that big compared to many other ETFs.

    I have no plans to the ETF but it is worth understanding what the pluses are before dismissing it.

  2. Roger – Thanks for the comment. Given the backtested data, we agree that the fund might very well turn out to be a good performer and a better option than IWO. My problem is that the term “asset class” is thrown around too loosely in an attempt to garner a patina of respectability. We should not confuse an investment strategy with an asset class.

    For instance, you and I could sit down with a decent database and generate a strategy with historical returns that are less correlated with the big indices and that has outperformed historically. But neither of us would claim that we have discovered a new asset class.

    We look forward to reading (and linking to) your next ETF article.


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