Monday, August 8th, 2016
changing classifications

In most of our endeavors, we seek to avoid ambiguity and are quick to classify people, places, things, whatever.  Those classifications make it easier for us to think in a shorthand way, taking some of the complexity out of the complex nature of everyday life (even while adding in the real possibility of errors in miscategorization).

Of course, investors are champions at this activity, breaking down our holdings into asset classes and style boxes and buckets of this and that.  It all seems so precise and definite, but it really isn’t.  There are lots of gray areas made to look like black and white — and the lines are drawn looking backwards rather than forwards.

Today’s classifications are soon to be out of date and, truth be told, the best money is often made by moving across the existing lines and into new territory, which is an anathema for those who like to plot out the landscape according to the current map and have carefully prescribed percentages of assets placed in each.

The status quo definitions tell us about how investors frame the world today, just as their progression over time charts the evolution of modern finance (which is still pretty much in its infancy).  An easy example is the mish-mash known as “alternatives” — the category was only on the radar screens of a tiny percentage of investment firms twenty-five years ago, while today even those in the hinterlands are debating whether to have ten or twenty percent in “alts.”

But that category shows how messy and ill-formed some of our groupings are.  Take hedge funds, for example.  Beyond the key commonality — a unique and badly out-of-date compensation scheme — there isn’t anything that would argue for hedge funds to be grouped together in an asset allocation breakdown, yet you see that they often are.

Their attributes vary greatly, depending on their legal structures, the liquidity terms on them, the raw materials (types of securities) used within, and the goal of each strategy as to the performance profile desired.  Therefore, a multi-dimensional categorization scheme is appropriate, and you can tell the serious players from the amateurs by how they slice and dice that category and others.

In general, better organizations have flexible, evolving approaches to categorization, even in mundane asset classes.  They understand that the world will change and that they should be anticipating that change rather than reacting to it.  In addition, to the extent that they can create their own codification schemes that differ from those that everyone else uses, they pack a powerful one-two punch:  a unique way of investing and a unique set of communications opportunities to go along with it.

But, in general, most organizations follow industry standards.  That means that change is afoot in the equity world, because of the addition of a real estate sector to the Global Industry Classification Standard (GICS).MSCI | This is the joint announcement from MSCI and S%P Dow Jones Indices, the arbiters of the categories in GICS.  It’s the first new sector since GICS came into being in 1999.  Since behavior follows benchmarks, you can expect to see adjustments in portfolio structure now that real estate is being broken out on its own.

Most classification changes aren’t announced officially, they just happen over time as pioneers approach the portfolio puzzle in new ways and (if they are successful in doing so) the crowd slowly comes around.

Institutional asset owners have been in the forefront of reworking their asset classifications away from the normal categories, in some cases coming up with new ways to divide up the existing assets, often by grouping them across the old asset class lines in accordance with how the investments perform.  Risk-based schemes are becoming more prevalent and, along another dimension, factor strategies have started to occupy a space alongside the ever-available beta and the elusive alpha.

Embracing such changes can lead to a big disconnect.  The staff of an institution may be looking at portfolio composition in new ways, while primarily reporting to its board using the traditional asset class view.  The same can happen with an asset manager and its clients.  The reporting infrastructure lags the changes in portfolio analysis — and it’s easier to talk about the portfolio in the same ways as you have before rather than explaining a new approach.

That disconnect leads to trouble, which is most likely to manifest itself during times of stress.  One group has been acting within a new framework, while the other was still thinking of the old framework as the defining feature of the portfolio.  It’s hard to make good decisions when you are on different pages.

In summary, organizations should view classifications as fluid and incomplete, and be constantly on the lookout for gaps to fill and improvements to make.  However, the drivers of new investment frameworks need to bring other stakeholders (clients, boards, etc.) along, through continual upgrades of the necessary reporting systems and careful communications about the benefits and risks of the new world view.  The payoff for doing so is real if little discussed.