Asset Class Taxonomy: A New Construct for Assessing Balance in Portfolios

Abstract

Investment innovation and the proliferation of alternative investments have rendered the current asset class taxonomy ineffectual. Moreover, private equity and hedge funds muddle understandings of risk in portfolios. The starting place for assessing a useful taxonomy is determining what is most important to investors from a diversification perspective. We observe that investors are most concerned with extreme market environments where more classical constructs for asset taxonomy fall short. We suggest that a taxonomy that articulates the main “drivers” of significant downside returns would complement existing methods for assessing diversification and convey important information to stakeholders. We offer three broad groupings that we feel give a high-level assessment of balance. More importantly, we provide a pragmatic framework for determining which sub-asset grouping should fall into each broad grouping. In short, we live with a commonly used taxonomy that materially misrepresents the risks and degree of diversification in portfolios. It is time that we reflect on the taxonomy of asset classes given the impact it has on the management of large pools of capital.

Keywords: Asset Class, Portfolio Management, Alternative Investments

JEL Classification: G11