Cost of Asset Allocation in Equity Market: How Much Do Investors Lose Due to Bad Asset Class Design?

Abstract

Many investors employ asset allocation, even though most are not really concerned about how their asset classification schemes affect investment performance. This article extensively examines the two most widely employed within-stock classifications: styles and industry classification. In order to explicitly measure current classifications’ performance levels, the authors introduce the concept of optimal asset classification, which provides the upper performance limit of any classification scheme. They find that style and industry classification are very costly. Furthermore, factor analysis reveals that the immediate cause of exorbitant cost lies in the method on which classification focuses.