Eugene F. Fama Jr. Vice President Dimensional Fund Advisors

July 2001

What Makes an Asset Class?

Sometimes NASDAQ is referred to as an asset class, but it's not. It's an exchange that contains several asset classes. A partial index of NASDAQ stocks might proxy for a tech stock "asset class"—but there's little theoretical reason to think tech stocks are an asset class either.

Talking about what is or isn't an asset class might seem trivial, but it's important because people use asset classes as key components of diversified portfolios. For this purpose each asset class needs to have a specific risk-return function.

Sorting securities on anything other than the dimensions of expected returns can fudge the clarity of the investment process and undermine portfolio diversification. When investors mistake where returns come from, the asset classes they assemble become arbitrary. This can lead to inadvertent tilts on the underlying factors that actually determine returns.

For example, investors sometimes manage industry exposure, as if sectors constitute asset classes. Analysts on TV talk about what companies produce and how it affects the prospects for their stock prices. As Adam Smith pointed out over 200 years ago, a company's industry bears no direct relation to the flow of capital.1 Expected returns relate far more to a company's health and size than to whatever the company makes.

In "Industry Costs of Equity", Fama and French cast Adam Smith's notion in an empirical light. They find that risk factors of market, size, and book-to-market seem to account for virtually all the differences in returns across industry groups (except real estate stocks, which for that reason probably constitute their own asset class). For example, if technology stocks have had spectacular performance, it's not because of a new business model, but because tech stocks happened to be growth stocks in a market that strongly favored growth. Lots of investors projecting ahead to a "new economy" were left holding the bag when growth stocks went out of favor.

We should instead set out to sort stocks along the true explanatory dimensions—in the above case by forming a growth portfolio—and include whatever industries happen to fit that asset class. After all, industries drift in and out of asset classes. They get bigger and smaller, healthier and more distressed through time. Tech stocks might be growth stocks today, but further earnings disasters could sweep them into the value category. Sorting stocks on secondary criteria like industries can therefore cause a portfolio to drift across asset classes.

Better to identify an asset class like growth stocks scientifically and use it for what it is: the polar end of a risk dimension that has always seen good times and bad. Let science fiction writers speculate about a digital future; investors should focus on the cost of capital.

A multifactor framework gives an easy way to decide major asset classes. Market beta, company size and value-growth represent dimensions of equity markets with their own risk-return profiles. Asset classes are most relevant when sorted along these dimensions, as combinations of "small cap," "large cap," "value," and "growth." These asset classes are transparent, focused, and consistent with economic research.

Here's a simple rule of thumb for assembling relevant asset classes using a three-factor "style map." Just as primary colors cannot be obtained by mixing other colors, primary asset classes are those whose plotted positions cannot be obtained by mixing other asset classes together. For instance, you can only get to the position of Large Cap Value in the lower right of the map by buying large cap value stocks. It is safe to conclude that Large Cap Value is a primary tool for positioning a plan in multifactor space.

Mid-cap stocks, popular as they are, are not primary components. By definition, they're neither large nor small, but fall midway in the size risk spectrum. Their exposure can be achieved with combinations of large cap and small cap asset classes, and doing so offers the additional benefit of micro-cap engineering and block trading "alpha" at the smaller end. It is therefore less obvious that Mid-cap is a primary asset class in a multifactor context.

Why is this important? Because, rightly or wrongly, structured investing dictates that we form total plans using asset class components. We sort stocks along specific risk-return dimensions and assemble them together like players on a team. To the extent any particular player does not distill its risk-return characteristics accurately and strongly, it distorts the overall plan structure.

Stocks can be sorted any number of ways that don't directly relate to expected returns. The dimensions of returns dictated by a multifactor framework can guide us to the most consistent and flexible way to characterize asset classes and achieve the best investment structure.

1. Smith, Adam, "Employment of Capitals", The Wealth of Nations, 1776.
2. Fama, Eugene F., and French, Kenneth R., "Industry Costs of Equity", Journal of Financial Economics, 1997.

Source: DFA