One of the most common questions we get at Elm is how we determine what asset classes qualify for inclusion in the Risky and Safe asset buckets in our portfolios and recently launched ETF. To explain our thinking, we’ve outlined the six criteria that every asset class must pass.

Risky Assets

For a risky asset class to be included in Elm portfolios it has to have all of the following characteristics:

• Low cost: It has to be an asset class which can be bought and sold via a low-cost vehicle, typically an index ETF or mutual fund
• Expectation of risk premium: We want to earn a structural risk premium in exchange for taking risk, while avoiding risks which shouldn’t be expected to carry a premium. The asset classes for which we should expect most or all of their risk to carry a risk premium are very large asset classes whose risk cannot be diversified away by investors at large, and which typically perform poorly when investors are also being pinched on their income and spending. For example, equities and real-estate clearly fall into this category, while individual stocks or other investments with significant non-systematic, uncorrelated risks do not.
• Ability to systematically estimate expected return: We need to be able to systematically estimate the expected return of the asset class, preferably using expected future cash-flows. We avoid asset classes where the only way to estimate the expected return is from realized historical returns, or from idiosyncratic analysis.
• Non-zero-sum: The investment does not require that someone else is taking an opposing position.
• Liquid: The asset class should have vehicles which can be easily tradeable with low friction, so that portfolios can be rebalanced without incurring significant transaction costs.
• Tax-efficient: For taxable accounts, we want the asset class to generate its returns tax-efficiently.

There are other characteristics we look for as well – for example we prefer large vehicles managed by large and reputable firms such as Vanguard, Blackrock, etc. We also want vehicles which have a well-constructed benchmark index principally based on market-cap weights. And sometimes we’re willing to hold liquid assets as a proxy for a less liquid asset class: for example we hold US Small-cap and Value ETFs not for exposure to the small-cap and value “factors” per se, but rather as a liquid proxy for US Private Equity.

We periodically review our list of qualifying asset classes as characteristics evolve. The chart below represents our analysis of various risky asset classes that we’ve considered. Only those that check all the boxes are included in Elm portfolios. We discuss high-level characteristics of many of these asset classes in our book The Missing Billionaires, specifically in Chapter 14 – “Into the Weeds: Characteristics of Major Asset Classes.”

Safe Assets

No assets are perfectly safe, but we require assets in this bucket to be as safe as possible, measured in terms of the spending over time the assets would support. For US investors, that generally means US Treasury obligations, particularly Treasury Bills and Treasury Inflation-Protected Securities (TIPS), but we also include small allocations (≤ 2.5%) to US Treasury and investment grade nominal bonds, and for US taxable accounts, high grade municipal bonds. In our fund for non-US investors, we also include inflation-linked government obligations of the UK and some Euro-zone countries.