I gravitated to asset classes fairly quickly when I first started trading. I had a 60 hour/week engineering job, and didn’t have the time to perform any kind of individual security analysis or sort through hundreds of individual stock charts each day. There were substantially fewer asset classes to keep track of, and that was manageable for me. This was in the early 1990s before ETFs were available, so I used individual mutual funds.
Most practitioners in the field define asset classes very broadly, such as stocks, bonds and cash. From these broad asset classes, there are sub-asset categories among stocks and bonds. For instance, Ned Davis Research1 divides the U.S. stock market into nine stock sectors and about a 100 industry groups. Morningstar splits stocks into nine style boxes with growth versus value on one axis, and small versus large capitalization stocks on the other.
Similarly, there are many bond sub-asset categories. Morningstar2 divides bonds along the dimensions of duration and credit quality. Add in foreign securities, and the number of asset classes starts to grow to a few hundred.
Throughout this blog, I’ll be pretty loose in my asset class definition. There are an infinite number of ways to slice and dice the universe of stocks and bonds to create a subset that has characteristics of interest for a trade; for instance, high-yield bonds issued from companies in the energy space, emerging market healthcare stocks, or dollar-hedged European stocks. Whatever the subset, I’ll still loosely refer to it as an asset class. Put another way, this blog is about trading groupings of securities that have one or more common features.
When trading asset classes, it’s certainly possible to group individual securities to form a trading basket, but just as they say “there’s an app for that”, there is usually a fund for that. If you manage a small hedge fund, or your own personal money, it’s usually easiest to pay the management fee associated with mutual funds. Here are the tools of the trade: exchange traded funds (ETFs), closed-end funds (CEFs), open-ended mutual funds (OEFs), exchange traded notes (ETNs), structured notes, futures, options on ETFs, and perhaps private partnerships, which are not traded.
According to Morningstar2, the premier tracker of all funds, there are 30,810 OEFs, 612 CEFs, and 1656 ETF/ETNs to choose from among the U.S. exchanges as of February 7, 2015.
Advantages of Trading Asset Classes
Here is a list of advantages associated with trading asset classes:
- Asset classes are less risky and less volatile than individual securities. Asset classes are not subject to the idiosyncratic risks associated with a single security. It’s almost impossible for the value of an asset class to go to zero. With individual stocks, a total loss of investment happens all the time, most often because the company did not compete well in the business world.
- Portfolio managers focused on individual stocks ultimately end up with a portfolio that acts like an asset class. For example, a small basket of Japanese stocks will perform similarly to the Nikkei 225. It may be easier to purchase a low-fee ETF and forget the stock picking.
- Life is simpler. Trading a single ETF is much easier and more convenient than building and trading a basket of stocks. There are many fewer asset classes to keep track of than individual securities. While there are over 30,000 mutual funds to choose from, most compete with each other among a couple hundred standard asset class groupings. Contrast that with the number of securities. Morningstar2 tracks 20,556 stocks and 2,437,648 bonds in the United States alone. To add value with security selection requires the incorporation of an enormous amount of information that can be generally ignored at the asset class level.
- With so much competition among stock pickers and bond managers, you may come out ahead (on average) buying the ETF. This is an efficient markets view, based on substantial evidence, suggesting that active stock pickers and bond managers have not added value in aggregate for the past 50 or more years. The competition among managers is so intense that most standard approaches to selecting individual securities have been arbitraged into uselessness.
- The old saying that there’s always a bull market somewhere holds with asset classes. If you’re a U.S. stock picker, and the U.S. stock market suffers through a 10 to 15 year secular bear market, it will be tough to generate interesting returns for investors or for yourself. I don’t like that kind of restraint.
Disadvantages of Trading Asset Classes
Here is a list of disadvantages associated with trading asset classes:
- By limiting yourself to asset classes, you have the reduced opportunity set to generate alpha. You are ignoring security analysis as a way to enhance risk-adjusted performance. You are ignoring profitable opportunities to trade individual securities to add value.
- Among the thousands of available funds, there often is not a perfect fund to play a particular trade or theme. Sometimes the best fund available is significantly diluted with other securities of passing interest. Buying the individual securities associated with the trading theme may be the best route.
- Fund fees create a performance drag compared to using the individual securities. Purists among hedge fund and mutual fund managers may be snooty around the use of funds because of the extra layer of fees, but for small portfolio managers, these fees are worth the price.
Ultimately there is no right answer as to what is best. If a person can add value at the individual security level, even within a single sub-asset class category, it can be a very lucrative business. I’m an asset class trader. If you handed me the keys to a long-only $1 billion equity mutual fund, I’d be hopelessly lost. I prefer the freedom to go anywhere in the world and to search among all asset classes to find trading and investment opportunities.
Notes and References
- Ndr.com. Subscription required.
- Morningstar.com, using the Morningstar Advisor Workstation 2.0. Subscription required.
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