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The tyranny of asset class boxes

Asset consultants like to define asset classes boxes. These are used to group investments of similar risk and return characteristics. They are also used to communicate the investment strategy of different member investment choices to members – think of the ubiquitous pie charts on product dashboards.

Asset class boxes are an intellectual tool to group similar assets together and allow parts on the portfolio to be optimised individually. That is, rather than assessing a potential new investment against all possible alternatives – the process is to, step 1, decide which asset class box it falls into and step 2, to decide if adding that asset improves the risk return characteristics of that box.

In the good old days these boxes very simple. They were Cash, Bonds, Shares and Property. However, as time has passed, the number of asset class boxes has grown (with a plethora of different and inconsistent names). A key driver of this growth is alternatives. First there was an Alternatives box – which covered assets that where neither simple listed shares or liquid high quality bonds. That is, Alternatives started as the box for assets that didn’t fit neatly in a box!

Now, as strategies grow in sophistication and complexity, most funds have boxes labelled “Defensive Alternatives” and “Growth Alternatives”.

What do these labels mean? Here is my simplistic interpretation of the labels – which is probably correct 80% of the time – but many funds and asset consultants have different definitions of these boxes.

Well you might say – that’s all very interesting – but what is the problem?

Bonds/Fixed Income is narrowly defined with only fully liquid high grade portfolios included.

As funds reach for yield, but want to maintain their growth/defensive splits (which are important for classifying which section of the monthly performance survey they appear in), they are increasingly including equity investments – most notably infrastructure equity – in the Defensive Alternative bucket.

This results in a Defensive Alternatives box which is quite crowded and contains things with fundamentally different risk profiles.

As an infrastructure debt manager – it doesn’t make sense to me that infrastructure senior debt gets put in the same box as infrastructure equity. This is effectively saying there is no significant difference in risk profile between debt and equity in the same asset!

That is ridiculous. Debt has seniority. Equity suffers (or benefits) from variability in returns/performance first. Debt’s cash flows are front ended. Equity’s large cash flows typically occur late in the life of an asset (see wind farm chart below).

In today’s era of potentially rising interest rates – this differential in duration may be critical. In particular, it is often the “safest” infrastructure equity assets (for example, PPPs) that have the most leverage and the most back-ended equity cash flows. This leaves them particularly exposed to a rising interest rate environment.

While it is important to acknowledge my frustration as a debt manager – I would also caution investors to take a step back and undertake a sanity check of their asset class box definitions and where they might be leading them.

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