In choosing asset classes for establishing strategic portfolio allocation across assets, the manager would most prefer that:
a) asset classes are only those with tradable liquid assets
b) the asset classes span the broadest universe of investable assets
c) correlations of asset returns within an asset class are significantly greater than correlations of asset class returns
The answer is b) apparently. But it doesn’t make any sense, surely one of the main objectives of effective portfolio management is to ensure that there are low correlations between assets in each class as well as low correlations between asset classes.
For example, in a theoretical portfolio, in which I allocate 50% to equities and 50% to fixed income securities I would want to make sure that both my equity allocation and fixed income allocation is fully diversified so that I am not assuming any (unnecessary) idiodyncratic risk. This would obviously involve me picking the best equities/bonds which have the lowest correlations with all other equities/bonds.
I suspect that you meant that the answer is c) apparently.
You’re misunderstanding the definition of an asset class. An asset class comprises assets that behave extremely similarly to each other under varying market conditions (and also are subject to similar regulatory control, and other irrelevant stuff). “Behaving extremely similarly” means having high correlations of returns. So if your asset classes are properly defined, you’ll have high correlations of returns within each class, and low correlations of returns between classes.
Your example demonstrates that “equities” and “bonds” are far too broad to be asset classes. Equities may comprise fifteen asset classes – with high correlations of returns within each class and low correlations of returns between classes – and bonds may comprise twenty asset classes. To get a well-diversified equity portfolio, you’ll want securities from each (or, at least, several) of those fifteen asset classes, and to get a well-diversified bond portfolio, you’ll want securities from each (or, at least, several) of those twenty asset classes.