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False diversification and the rise of novel asset classes

One of the many disappointments of the current crisis has been the utter failure of diversification to shield investors from harm.  Absent an investment in plain vanilla Treasuries every asset class has seen historically poor performance.  While every one would agree these are unique times that does not erase the losses that have already occurred.

The rise of so-called novel asset classes has lead some investors to diversify their portfolios with investments that are not novel at all.  They simply constitute the incorporation of a narrow industry sector or strategy into an ETF form.  This false diversification lead some investors to feel that their portfolios were less risky than they actually were.

We touched on this problem a long-time ago in a post entitled:  What defines an asset class? At the time it was becoming clear that the ETF industry was going to slice and dice the investment universe in search of additional product.  Most of these novel strategies that looked so good in backtest form have not held up in the current market environment.

This is all in order to note an important post over at All About Alpha on why hedge funds are not an asset class.  In it they cite eight criteria from Alan Dorsey on what is a true asset class.  A quick taste:

The first is that it must have an “intrinsic value“.  In other words it must provide a return that is not “speculative” and must have an “implicit rate of return”.

Hedge funds are an aggregation of all manner of investment strategies.  Trying to mold a coherent case for them as an asset class is difficult at best.

The challenge for investors still seeking diversification is in trying to substantiate what constitutes a truly novel asset class, and what is in actuality simply a sector fund or investment strategy masquerading as an asset class.  The last few years have blurred those lines.  Unfortunately many investors are paying the price for that now.

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