Asset classes

From this year’s mock…

Given the asset class set: (Large cap, mid cap, small cap, Agricultural Commodities Index, All Commodities Index, Municipal Bonds)

When evaluating the asset classes in Exhibit 1 (the one’s I listed above), Roth would most likely criticize the specification of which of the follow asset classes?

A) Mid cap equities

B) Taxable muni bonds

C) All commodities Index


I thought to myself, awesome, these will be easy points. Clearly the “All Commodities Index” 1) is not mutually exclusive from the Agricultural Commodieis Index and 2) is not homogeneous, as some commodities are storeable and linked to economic activities which provide a good inflation hedge while others are poorly linked to inflation. Should be easy points right?


Roth would most likely criticize the specification of mid-cap equities because they are not mutually exclusive with respect to domestic large-cap and small-cap equities. Asset class specification should support the purposes of strategic asset allocation. Domestic large-, mid-, and small-cap equities are assets within the asset class of domestic equities and have little diversification benefit between them, with the correlation between their returns being very high."

I did the same thing, and asked the same question on here. You have to look at the correlations. The All Commodity Index only has a 0.55 correlation to the Ag Commodity Index, but the Mid Cap index has over a 0.96 correlation to the Large Cap. So there is overlap in both, but the Midcap is “more” likely to be criticized for not being homogeneous.

Agree with your answer

Asset class first three criterias, CFA solution only meets the “diversifying asset classes” one.

  • Homogeneous (Within asset class)

  • Mutually exclusive

  • Diversifying asset classes

Taxable muni bonds? Is that a typo?

I still disagree, strongly. The Ag Commodity Index may be a small subset of the All Commodity index - leading to the low correlation. However, if it is a subset of the all commodity index the requirement of mutual exclusivity has been violated. Furthermore, the correlation between asset classes can become highly correlated in certain circumstances - i.e. real estate and equities during the financial crisis. That does mean they suddenly become the same asset class.

I think your initial answer, and the answer I am sticking with, is correct unless someone can explain how “All commodities” somehow implicitly excluses the Ag commodities - I thought all meant all and frankly these ambiguous questions get me really frustrated this close to the exam.

Exactly. Now if the question had said, “Based solely on the correlations, with which asset class would he have had a problem?” then I could see ignoring the other defining characteristics. For me, the clear and undeniable indication is that the exhibit explicitly lists an “All” commodity index in addition to another commodity index - indicating exactly that mutual exclusivity has not been upheld. We can debate what is “high” correlation and what is “low” correlation - that is a subjective line in the sand. But mutual exclusivity is black and white. It has been violated and therefore it is the MOST LIKELY to be objectionable.

Good point - I have no idea what that means.

There’s no debating what is a high corrleation and what is low when the CFAI text explicitly states that “A pairwise correlation above 0.95 is undesirable.” In the problem, midcap equities have a 0.992 correlation to Large Caps and a 0.983 correlation to Small Caps. Overlapping asset classes should not be included, and while both Midcap equities and All Commodities overlap with other available asset classes, Midcap equities does so to a higher degree. All Commodities is not mutually exclusive, but at least it is diversifying. Midcap equities is neither mutually exclusive nor diversifying.

Okay, thats not a bad explanation … but I think it is a REAL stretch. No where does it say how they’ve defined small cap / mid cap / large cap. It is very possible that they are, in fact, mutually exclusive so long as the upper-bound on small cap is at or below the lower bound of mid cap and the upper bound on mid-cap is at or below the lower-bound on large cap.

Undesireable does not mean a violation, either. The only case in which there is undoubtedly a black and white violation is in the case of the two commodities indices. Not to mention that the ‘All Commodities’ asset class is not homogenous, another trait NOT violated in the midcap equities specification.

^It’s not a stretch… and they didn’t ask “which asset class is most likely to be in violation?” They asked, "which asset class is he most likely to throw a fit about ? In other words, which asset class is he going to have the biggest problem with (i.e. there might be several asset classes in violation of being properly specified, however, there’s one asset class that just has all sorts of sh!t wrong with it).

Well, we’ve boiled it down to two possible asset classes:

  1. All commodities

  2. Mid-Cap

wct’s explanation above does a fine job. delineating the two.

I missed this question, too. Had the exact same initial thought process you did. Then, I realized my explanation above and got over it. The whole idea behind getting into different asset classes is to mix up your exposures and diversify. With a .992 and 0.983 correlation, there’s essentially zero diversification.

I see what you’re saying but still disagree.

Having different asset classes is about diversification, yes, but it is also about sourcing returns and define risk exposures. Dividing the domestic equities by market cap and calling them different asset classes is a WELL accepted practice.

Correlations are not time-independent, either. They vary over time. The correlations provided in the table do not specify a time period. Could be one week, one month, one year. If they were weekly correlations, yeah 0.999 would be undesireable but may be acceptable.

What is absolutely NOT acceptable is having asset classes that are not mutually exclusive. We keep reverting to the assumption that midcap is not mutually exclusive from large-cap and small-cap. It is as simple to divide equities into two mutually exclusive parts, large-cap and small-cap, as it is to divide them into 3 mutually exclusive parts. But “ALL” commodities clearly includes the Ag commodities.

Anyway, WYL, you’re right - we might as well move on.