As we have seen in chapter six, asset classes are not homogeneous in terms of their risk reward characteristics. A UK large cap fund has very different risk reward characteristics from a Korean small cap equity fund. Likewise, there are wide differences between the various hedge fund strategies and managers.

This does prompt the question of how to define asset classes and sub-groups within them. One way of defining them is according to their expected response to economic conditions, such as price inflation or changes in interest rates. The weighting to different asset classes will also be determined by their relative risk adjusted returns and correlations. The key is to combine asset classes to provide the highest expected return for a given level of risk or the lowest level of risk for a given level of return.

Analyse the characteristics of different asset classes to decide the role they can play in your portfolio. For example, they may be divided into UK equities, bonds, international equities, absolute returns, private equity, property, commodities and cash. Studies have suggested that equities are more volatile and therefore risky than bonds over the short term. Over the longer term, however, the volatility of after-inflation returns of equities falls lower than bonds. This means you should have a significant exposure to equities if you want capital growth over the long term.

It is argued by some wealth managers that you should only hold a sufficient proportion of bonds to protect the portfolio against financial uncertainty. This frees up assets to diversify into alternative asset classes and therefore reduce volatility without sacrificing returns to do so.

Absolute return strategies, which include hedge funds, are designed to generate positive and steady long-term real risk-adjusted returns. Some commodities can protect the portfolio against inflation as they represent “claims or future streams of inflation-sensitive income”. Some can provide stability for the portfolio during periods of stock market turmoil although this comes at the cost of an inability to keep pace during bull markets for equities.

It is not only for diversification benefits that you should consider alternative asset classes. They can also be more predictive although this does not mean they are predictable. Commercial property and fund of hedge funds can, for example, deliver steady returns.

If you are looking for wealth protection then alternative asset classes like hedge funds and commercial property will have a larger role to play in the portfolio. 

Taking a longer term approach to investment means you do not need to be so concerned about liquidity and therefore can have greater exposure to private equity and property.

Highly liquid large cap stocks receive extensive coverage and therefore it is difficult for investors to gain a significant advantage. In contrast, less liquid and small cap stocks have less available information and thus the opportunity to generate out-performance.

Furthermore, liquidity tends to increase and decrease as the popularity of the underlying assets waxes and wanes. Once illiquid investments succeed, liquidity follows as investors clamour for shares. If liquid investments fail then liquidity dries up as it falls from favour.