One of the great cosmic tragedies in the past few years was the sad demotion of Pluto from a planet to a mere “planetoid”.  After decades enjoying the exalted status of a true planet, the poor thing was summarily dumped by a vote of non-confidence from the International Astronomical Union in 2006.  Yeah, we know – everyone shed a tear for Pluto that year.  But it turns out the little ice ball was never a planet anyway, but just part of the Kuiper Belt, a ring of various flotsam and jetsam circling the solar system.

Despite being referred to as an “asset class” by the popular media for over a decade, hedge funds may someday meet the same fate.  The issue is not that they are large enough – or even that their returns are high enough.  Rather, the issue is that they simply fail to meet a number of key criteria for a “true” asset class – most notably the essential ability to coalesce around a central unifying return driver.

Alan Dorsey’s book Active Alpha (listed in our recommended books section) contains a great litmus test to determine what is and isn’t a true asset class.  Much of the book can be viewed online here.

Dorsey says that asset classes must meet 8 criteria:

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”.  On this basis, argues Dorsey, currency is not an asset class because currency does not provide any intrinsic value.  Instead, any returns from currency investing are purely “speculative” in nature.  Real Estate, on the other hand, does have an intrinsic value – the present value of all future cash flows produced by it.  While the strategies pursued by hedge funds (such as merger arb) may have an intrinsic value (merger insurance), hedge funds in general deliver no common and defining intrinsic value.

The second is that it must provide “adequate liquidity“.  As the media has been reporting ad nauseam recently, hedge funds don’t excel at providing investor liquidity.  And one could easily argue that making them liquid would remove their illiquidity premium and thus remove part of what defines a hedge fund.

The third test is that it should have a low correlation with other asset classes.  While many traditional asset classes have relatively high correlations (e.g. small cap US equities and large cap US equities), one of the very rationale behind demarcated asset classes is to exploit the benefits of diversification when combining them.  Hedge funds score well on this measure since they have a relatively low correlation to other asset classes.

Fourth, Dorsey says that the constituents in a true asset class are homogeneous.  Many traditional asset classes contain funds or individual securities with great similarity.  Hedge funds, alas, are the financial equivalent of that bar in Star Wars with all the weird-looking, odd-ball aliens.

He argues that the risk of a true asset class is “estimable“.  As we now know all too well, the “fat tails” in hedge fund returns make it very difficult to estimate their true risk.  In other words, their volatility is itself volatile.  (Mind you, Black Swans live in equity markets too.)

He says that in true asset classes, “structures and regulation are not impediments to investing”.  Obviously, many hedge funds fail to qualify on this measure as well.

Seventh, Dorsey says that in order for an investment category to qualify as a true asset class, there must be a “large pool of talented managers”.  There are thousands of hedge fund managers in the world.  But, by definition, only a few that can exploit each unique return driver argues Dorsey.  Hedge funds, after all, aim to exploit unique and yet-unexploited market anomalies.

Finally, Dorsey says that there must be passive benchmark available that tracks the performance of the asset class in aggregate.  This is perhaps the most contentious issue in the hedge fund industry today.  Can hedge fund returns  – themselves an active strategy – be replicated with a passive index?

If hedge funds delivered pure alpha, their aggregate return should, in theory, be zero each year.  Alpha is, after all, a zero-sum game.  But hedge funds produce positive returns in most years.  Critics say this is due to simple equity beta seeping into their returns (e.g. Q3, 2008).  So if hedge funds are really just packagers of market beta (along with other betas and perhaps some alpha), then it’s the beta, not the hedge fund itself, that should be the basic unit of analysis for portfolio construction.

In fact, most traditional asset classes don’t fit the mold either.  So why not throw out the entire concept of “asset classes” while we’re at it?

As it turns out, this is exactly what Dorsey concludes too:

“The inclusion of factor analysis in order to more accurately appraise both the independent and the interrelated attributes of all traditional and alternative investments helps to move beyond the definition of asset class and its rigidity…

“As alternative investment strategies blur and overlap, and ability to compare identical return drivers across disparate strategies is critical for an investor’s success and ability to construct an efficient portfolio of alternative investments.”

As a financial “Kuiper Belt”, hedge funds lack the gravity required to coalesce as a singular point in space.  As a result, they are spread out around the financial system.  On the other hand, traditional asset classes are big, well recognized and visible with the naked eye.  But they only exist at one point in space.  But at the end of the day, the debate over Pluto ’s status and Alan Dorsey’s minimization of traditional asset classes both go to show that traditional labels die hard.