Historically noncorrelated asset classes can become correlated during times of market stress
There are several ways to create an extra layer of diversification
Alternative diversification solutions can be ultra-complex, expensive, risky, and not fully accessible to all investors
You’ve followed all the rules in the proverbial diversification playbook. Your stock and bond picks are fundamentally sound and well balanced. Your positions sit within your personal risk limits. Overall, your portfolio is well diversified and set for the long haul.
Then an unprecedented event rocks the economy, and your entire portfolio—nearly 100% of it—takes a nosedive. So much for diversification, right?
It does happen. In times of market stress, traditionally noncorrelated assets may suddenly become correlated. Sometimes it’s a temporary phenomenon. Sometimes it has some staying power, but time has tended to right the ship eventually—historically speaking.
The key is how investors react. Many have a tendency to throw the baby out with the bathwater, but there are other approaches. When a crisis-like market environment “equalizes” asset behavior, diversification may suggest an alternative approach.
Situation Normal: All Fouled Up
Why might this “correlation breakdown” happen? Many of us assume that if a portfolio is diversified enough, some assets will rise or hold steady while others decline. That can be true most of the time, but not always. When the economy is under extreme stress—enough to get investors worried that it might buckle under the strain—risk aversion sets in, panic-selling ensues, and investors sell assets for cash across the board.
Asset classes that are traditionally noncorrelated—stocks and bonds—can suddenly begin marching in single file toward the proverbial meat grinder. They could end up looking and performing like a singular, concentrated mass.
You know that proverb, “A rising tide lifts all boats”? This is the opposite.
If an ebbing tide is in danger of lowering all boats, perhaps it’s time to cast a wider net. In other words, think about creating that next level of asset diversification.
Leveling up sounds like a good plan. But how might you do it, and is it worth the cost and effort?
When correlations break down, it usually means the market’s shot. And when this happens, the Federal Reserve steps in to provide monetary stimulus. But injecting additional liquidity into the financial system tends to increase the likelihood of inflation. In essence, more money in the system tends to dilute the value of the dollar, gradually eroding its purchasing power over time.
So how might you hedge your traditional portfolio against a fall in asset values and purchasing power? Here are a few alternatives, each with its own unique characteristics and caveats.
Gold has historically been considered a traditional and popular “safe-haven” investment. Might it hold steady or rise when stocks and bonds fall? Sometimes. Might it gain value during periods of inflation? Most of the time, although not always in lockstep. But might it be a potential investment that’s often uncorrelated with stocks and bonds? Yes, and that last point matters when it comes to diversification. Just be sure to do your research. There are many kinds of gold exposure: physical products such as coins and bars, mining stocks, exchange-traded products (ETPs) such as ETFs and ETNs, and gold futures. You don’t want to pan for the wrong “gold” given your objectives and risk tolerance.
This means oil, wheat, cocoa, feeder cattle, lumber, copper, and so on. Commodities can offer exposure that’s noncorrelated to the stock market. There are several “commodity classes” to choose from, but be careful, especially if you’re thinking of futures (you can end up losing more than what you have in your account). Also, remember that commodities have their own bull and bear cycles, and sometimes those cycles coincide with a stock market selloff. Crude oil, for example, cratered in the spring of 2020, just as stock markets across the world were engulfed in coronavirus panic. So individual commodities can, at times, be subject to this “correlation effect.”
Perhaps taking a diversified approach—as in a broad commodity ETF—might be a more favorable approach. That way, your commodity diversification can also aim to be diversified.
Next on the list are a few lesser-known alternative investment types. Most investors aren’t familiar with these, so they might make your head spin a bit. Most are accessible only to high-net-worth investors. When approaching these strategies, you really need to do your research and dig deep into the prospectuses and accompanying material, as some of the investments may be highly complex and charge high management fees. Plus, because some of these strategies take time to unfold, they’re subject to lockup periods, meaning you can only access your money at certain intervals.
For these reasons, as mentioned, some of these investment types are targeted specifically for so-called “high net worth” individuals, and you must meet asset or income thresholds in order to invest.
- Absolute-return investments. Absolute-return strategies aren’t as focused on market direction (bull or bear) as they are on a fund manager’s skill in generating returns across all types of market conditions. To achieve this, the manager can use a wide array of methods such as short selling, various kinds of arbitrage, and macro-strategies covering commodities, foreign currencies, and foreign interest rates. Remember, the opportunities and risks in this approach depend on the individual manager more than the assets he or she trades.Global macro funds. Global macro funds are actively managed strategies that aim to capitalize on global political and economic events. For example, in 2016, a fund using this strategy might have speculated on the outcome of the Brexit vote. These funds can use any asset to build a market position. Again, the focus is on major global events. Multi-strategy funds. Some firms take the top-performing strategies and roll them into one, like a “fund of funds,” to create diversification at the strategy level. You’re probably familiar with asset or market diversification. But strategy diversification? It’s something to think about.Risk parity. If you’ve never heard the term before, “risk parity” is a portfolio management approach that focuses more on balancing risk than allocating capital. If we just lost you there, don’t worry. It’s a complicated concept. Think of “all-weather” portfolio strategies that’re designed to handle any kind of market environment with minimum volatility. If you can imagine this, then you can get a sense of what a risk-parity approach is all about.
The Bottom Line
When markets experience a major and prolonged tumble, asset correlations can go out the window and so too can traditional diversification methods. Some alternative asset classes can add a layer of noncorrelation to a portfolio and help keep things afloat during troubled times. But they come at a price, and they come with their own unique and often significant risks. If you’re looking to create that next level of diversification, choose carefully and make sure the cost is ultimately worth the cure.
Alternative investment strategies are subject to greater volatility than investments in traditional securities and are not suitable for all investors. Investments may include derivative instruments, including options, futures, swaps, structured securities and other derivative instruments which may involve a high degree of financial risk. They may also invest in foreign securities, which may be more volatile than investments in U.S. securities and will be subject to currency and political risks.