Sanity Check: Differences in Investment Classification.

The nuances of classification 

Classifying groups based on common attributes is a widespread human practice, for example the Periodic Table and biological taxonomy. The classification of investment instruments into asset classes is arguably more comparable to the classification of animal species, than the meticulous rules defining where an element falls on the Periodic Table. 

Investments are instilled in mathematics where the perception is that rigorous rules and formulas define all elements of the profession. This is not the case: a good deal of subjectivity is required. 

Classifying asset classes 

Traditionally investments are classified into four primary asset classes: cash, bonds, equity and alternatives. If an investment instrument cannot be neatly boxed into any of these asset classes, it is typically classified as an alternate investment.  

Once an investment is objectively defined, subjective considerations come into play. This is far more nuanced and diverse, with typical categorisation buckets including: 

• Geographical: Where is the instrument listed, tradable and/or generating its revenue?  

• Issuer: Is the instrument issued by a government, a municipality, a parastatal organisation, a listed company, an unlisted company, or a one-man shop? 

• Sectoral: What sector of the economy is the instrument’s issuer operating in and how granular is this definition?  

• Size: How prominent is the instrument’s issuer in the investment world?  

• Ratings: Do industry or regulatory bodies grade the investment instrument or issuer with a proprietary score?  

• Duration: Does the investment instrument have a measurable maturity, investment horizon or term?  

• Factor: Does the instrument or issuer exhibit certain market factors?  

• Other: This could be ANYTHING that groups similar things together. E.g. FAANG stocks, sin stocks or disaster bonds. 

Subjective buckets often become convoluted and intertwined into complex combinations. Grouping an investment instrument by its size, factor and sector is not uncommon. Technically these are just very granular asset class definitions. 

Why are investment instruments classified in different ways? 

Differing asset allocation statements for the exact same portfolio, is a widespread problem across the industry and leads to considerable confusion. The domicile of a data provider tends to play an important initial role in how an instrument gets classified. A European data provider would tend to classify investments into buckets of Europe vs the “Rest of the World”. These buckets would however be rather arbitrary/meaningless to a US investor, who would probably prefer to know their portfolio’s US exposure vs the “Rest of the World”. 

Further inconsistencies arise when data providers have different interpretations of how instruments should be grouped. There are objective differences such as financial reporting standards (E.g. US GAAP3 and IFRS4). Obscure differences such as regional definitions, should South Korea be grouped as an Emerging or Developed market? Is the cut-off point for a “long duration” bond 10 years or 15 years? Which ratings agency should be used to determine an instrument’s credit rating? 

A single difference of opinion in any of the above criteria, leads to two different asset classes popping into existence and two differing account statements being created. Producing any investment report is a data intensive exercise, reliant on automated processes and programmed rules. Catering for all potential perspectives, users, edge cases and situations quickly becomes impractical.