How granular should the asset class universe be when setting CMEs?

Question

AcadiFi · Accepted Answer

This is a practical tension that every CME team faces. The answer depends on your firm's investment process and how it makes allocation decisions.

**The Principle: Mirror Your Decision Hierarchy**

The asset class universe should reflect the key dimensions of decision-making in your investment process — no more, no less.

**Example 1: Simple Wealth Management Firm**
If your firm makes three main allocation decisions (how much in stocks, bonds, and alternatives), you need three broad asset classes. Breaking equities into 11 GICS sectors would be overkill if you don't make sector-level allocation decisions.

Universe: US Equities, Int'l Equities, US Bonds, Real Estate, Cash → 5 classes, 15 correlations

**Example 2: Sophisticated Institutional Manager**
If your investment process involves sequential decisions — first geography, then within each region, style and size — you need a more granular universe:

Universe: US Large Growth, US Large Value, US Small Cap, Europe, Japan, EM Asia, EM LatAm, US Govt Bonds, US IG Corp, US HY, EM Debt, Real Estate, Commodities → 13 classes, 78 correlations

**Why Keep It Small:**
Every additional asset class requires:
- 1 more expected return estimate
- 1 more volatility estimate
- (n-1) more correlation estimates

For 6 asset classes, you need 27 inputs. For 13, you need 104 inputs. Each input is a source of estimation error, and the optimizer amplifies those errors. The more inputs, the more noise in your allocation.

**The Multi-Dimensional Challenge:**

The data needs to be sliced across multiple dimensions:

| Dimension | Examples |
|---|---|
| Geography | Global, regional, domestic vs. foreign, economic blocs, individual countries |
| Major asset class | Equity, fixed income, real assets |
| Equity sub-classes | Styles (growth/value), sizes (large/mid/small), sectors, industries |
| Fixed-income sub-classes | Maturity, credit quality, fixed vs. floating, nominal vs. inflation-linked |
| Real asset sub-classes | Real estate, commodities, timber, infrastructure |

Different firms prioritize different dimensions. One firm might segment global equities primarily by GICS sector (treating the world as one market), while another prioritizes geography first (US vs. Europe vs. Asia) with sector as a secondary consideration.

**Exam Tip:** If a vignette describes a firm's investment process, the correct asset class universe should align with how that firm makes its allocation decisions. If the firm doesn't make active sector bets, sector-level CMEs are unnecessary.

Dive deeper into CME framework decisions in our CFA Level III articles.

How granular should the asset class universe be when setting CMEs?

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