Wednesday, May 20, 2009

Asset Class Labels - Ari Paul

The traditional classification method looks at the asset itself (commodity, equity etc). Alpha’s method looks at the investor’s claim on the asset (real, fixed, residual, or derivative). Both are important to understand the nature of an investment. For example, physical ownership of crude oil behaves very similarly to a collateralized oil future, so the traditional method does a fine job. On the other hand, a derivative claim on real estate (like a highly leveraged CDO) behaves nothing like real ownership of real estate; Alpha’s investor claims method is much more accurate in this case.

I’d like to add yet a third dimension to classifying investments that will hopefully clarify rather than complicate. That third dimension is strategy. By “strategy” I’m not referring to the strategy of the fund or portfolio (e.g. long/short), but rather the reason for purchasing a specific asset. We can categorize the purchase of any asset as arbitrage, market making, value investing, growth investing, macro, or pattern. I’m using these terms a little differently than they are usually applied to portfolio strategies. Arbitrage is strictly zero risk trading (e.g. buying a contract on one exchange and selling an identical contract on another exchange at a higher price.). I’m using “market making” to refer to an asset purchase motivated by the belief that the price has been temporarily depressed by order flow (e.g. a customer faces a margin call and is forced to sell a stock to you). Value investing means purchasing an asset below its current intrinsic value. Growth investing is purchasing an asset as a bet that its intrinsic value will increase. Macro refers to betting on political factors like interest rate changes and other systemic factors. “Pattern” refers to any kind of quantitative trading whether based on mean reversion or trend following.

This third dimension is sometimes the most revealing about the risks and expected returns from an investment. For example, if you learn that a class of hedge funds are facing investor redemptions and must liquidate their portfolios, you may buy many classes of assets and investor claims from them in the belief that prices are temporarily depressed from the forced selling (market making). This strategy may be coupled with fundamental analysis that the assets are undervalued (“value investing”). The same analysis and many similar pitfalls apply whether you are buying equity derivatives or physical silver from the distressed sellers.

I think each classification method adds value, and there’s no reason to limit ourselves to just one. As an investor, I evaluate any purchase by all these criteria. We should ask the same of anyone managing our money. What type of assets are they buying? What claim to those assets do they have? Finally, why are they buying those assets? Together, the answers to these questions can help us answer the real question: what is our expected return and what are our risks?

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