The greatest rebalancing bonus is comes from investment categories with a correlation below 0.85, but correlation varies significantly based on the time period measured. While most categories do not have correlations below 0.85, there are several that do. Too many, in fact, for all of them to be asset classes. This makes the selection of asset classes somewhat of an art.

For example, U.S. stocks and foreign stocks have a low correlation to one another. But emerging markets also has a low correlation to U.S. stocks and to foreign stocks. Should emerging markets be its own asset class?

In cases like these by measuring the historical correlation, we can determine which low correlation asset class candidates move the most together. Then, it is good to take the two categories which are most similar and use them as underlying sector divisions within the same larger asset class.

Sectors divisions are strategically less important to keep in balance because their correlations are often higher than the correlation between asset classes. However, because of their relatively low correlation or other favorable attributes, you can still receive a rebalancing bonus from moving between them.

Finding these sector divisions rounds out your asset allocation. Although asset classes can tell you the general direction to move when your portfolio is out of balance, sector allocations help determine which type of security is the best to purchase.

Sector definitions serve as reminders of your strategy. They can be used to remind you of low correlations within your asset classes as well as other strategic decisions.

Within an asset class, there often exist further partitions which may at times over or underperform the category as a whole. The lowest correlation sectors, as we mentioned before, are the greatest candidates for independent movement, but sometimes even a highly correlated sector sees better returns than the asset class as a whole.

For example, many investors use the S&P 500 Index to represent the asset class of U.S. stocks. This index is comprised entirely of the large cap sector. However, some sectors of the U.S. stock market have measurably better or lower historical returns than the returns of the S&P 500.

A strategy of investing more in the categories with historically higher returns and less in those with less desirable returns is one of the best strategies for subsector selection.

In the U.S. Stock category, some of the best returns are found by tilting toward small cap value and by avoiding small cap growth. Using these historical returns we can craft a style box sector allocation which should have expected returns that are superior to less sophisticated allocations.

Superior expected performance should be evaluated in relation to greater than normal volatility. Although small cap value has the highest expected return, it also has the highest expected volatility. Mid-cap value has a better risk adjusted return. And an allocation to large cap stocks can help mute the already inherently volatile markets.

A sector with higher than normal historical returns and volatility might be over weighted in just the right small proportion to find the optimum point on the risk return curve.

The optimum mix may also vary depending on market conditions. One example is using the ratio of forward P/E ratios to dynamically tilt between small and large cap styles or between value and growth. Forward P/E ratios can help determine if one category is priced higher than normal or selling for bargain prices. These valuations tend to run one way for a few years before switching. This allows investors to take advantage of the trend without frequent trading costs.

Switching the allocation of your U.S. stock asset class between large and small cap stock based on their forward P/E ratio allows you to keep your top level allocation in balance while strategically overweighting the subcategory you expect to have better returns.

The division of an asset class into sectors is limited only by available information on your investments and the ease of purchasing investments which fit those divisions.

The Healthcare and Technology sectors of the U.S. economy tend to outperform other sectors making them worth overweighting. Emerging Market stocks have the advantage of inexpensive labor costs and tend to outperform stocks in developed countries. Stocks in countries high in economic freedom and low in debt and deficit tend to outperform those in less free countries.

While these are all examples of subdividing stock asset classes based on higher than average expected return, you may have a very different selection criteria for divisions of bond asset classes.

You put money into bond asset classes because you want your investments to be more stable. Therefore, you may choose to overweight the less volatile subcategory of a bond asset class.

The U.S. Aggregate Bond Index includes high yield junk bonds, questionable municipal bonds, and long term corporate bonds. While these categories may have higher than average returns, they also act more like stocks. Normally we want our allocation to U.S. Bonds to be more stable and secure. As a result we purposefully choose safety and settle for less return. This choice allows us to allocate less to the U.S. bond category and put more into appreciating assets.

Asset classes are selected for their lack of correlation and timeless strategy. Sectors are selected strategically to boost returns and take advantage of leading indicators.

There are hundreds of potential security categories. Only some are worth including in your investment strategy. Most are not part of the efficient frontier. We believe that crafting a brilliant strategy should come before selecting specific funds or investments.

Being out of balance at the higher levels has a greater consequence because correlation is lower among different asset classes. But since rebalancing is executed at the lowest layer of categories, the selection of every category is important to investment returns.

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