Explain how asset classes serve as building blocks for systematic risk exposures and set out the tests for defining an asset class

An asset class groups assets that share systematic risk exposures, so the allocation decision becomes a choice of exposures. A well-specified class meets several tests: its members are similar in risk and return characteristics; classes do not overlap; each diversifies the others, so its inclusion expands the efficient frontier; together the classes cover most of the investable wealth available; and each can absorb a meaningful share of the portfolio without liquidity problems. Diversification should be judged across the whole opportunity set, for example by regressing one class on the others, not only through pairwise correlations. The trap is creating classes such as domestic large-cap and all-cap equity that overlap heavily and add nothing but estimation error.