Alternative diversifiers: Rethinking diversification in investment portfolios

Investors who forecast the stock-bond correlation to be -0.5 expect their forward-looking return and risk levels to be in-line with the dark blue frontier. A hypothetical investor who allocates to a 50/50 portfolio, based on an expectation of -0.5 equity-bond correlations, expects a portfolio return of ~6.3% and annualized volatility of ~7%. However, if the expected stock-bond correlation was +0.5 instead, the expectations would move to the orange frontier, resulting in a portfolio volatility of ~9.5%.

To account for the fact that the equity-bond correlation may remain positive, the investor is faced with a difficult choice. If the portfolio allocation was unchanged to maintain return expectations, a potential increase in portfolio volatility to ~9.5% would need to be accepted. If the investor decided that they did not want to potentially increase its volatility beyond initial expectations, they would need to de-risk their portfolio to 20% equity and accept a lower expected return of ~5.7%.

Alternative diversifiers can help with downside risk management

Investors who want to limit the impact of stock-bond correlation uncertainty on portfolio outcomes need to look at other options that can complement fixed income and help with robust downside management. One option for investors is to include an allocation to alternative diversifier strategies such as active long volatility and cross-asset trend. These strategies are expected to exhibit a negative equity beta when equities decline and are not expected to be impacted by changes in the stock-bond correlation. We find that allocating to these strategies can help reduce total portfolio drawdown risk and the reliance on bonds for drawdown protection without introducing illiquidity⁶ into investment portfolios.

• Active long-volatility strategies: Long volatility strategies serve as a reliable hedge for mitigating portfolio drawdowns during downturns in equity markets. For example, an investor seeking drawdown protection can systematically buy a defensive option that becomes valuable when the underlying equity index falls below a specified price. The option pay-off is agnostic of what causes the equity index to fall. Therefore, unlike duration, the payoff is not dependent on inflation regimes or business cycles. However, the higher certainty of protection comes at a cost that can at times be exorbitantly high. Active long-volatility strategies can help significantly reduce the cost of protection by using active processes to modulate exposures to derivative instruments, including equity index options and VIX futures, in a way that maximizes portfolio protection while minimizing costs (including time decay or negative carry). Using pattern-recognition and other conditional processes, these active long-volatility strategies lie somewhat dormant when volatility is low, and will increase exposure when the probability of a market crisis increases. In this way, portfolio protection increases for active long-vol strategies as market risk increases.
  
  
• Cross-asset trend strategies: Cross-asset trend strategies can play a crucial role in creating defensiveness in a portfolio by systematically capturing both upward and downward price movements across various asset classes. These strategies use a variety of medium-to-long-term trend algorithms to initiate long or short positions across equity markets, fixed income, commodities and currencies. By adjusting positions in response to market trends—buying assets that show positive price changes and shorting those with negative price changes—these strategies can generate a positive return in both up and down markets.⁷ During unexpected inflation shocks, when stocks and bonds struggle, trend-following strategies can enhance portfolio defense by going long on commodities, which typically benefit from inflation. This diversification helps mitigate portfolio losses when stocks and bonds are positively correlated and are both generating negative returns. Historically, trend strategies have performed well in market dislocations, such as during the Global Financial Crisis when they profited by shorting crude oil and gold and by being long U.S. dollar and the Japanese yen.

While both active long volatility and cross-asset trend can provide defensive properties in equity down-markets, they are not exposed to the same risk factors⁷ and have properties that make them complementary allocations.

The protection from active long volatility comes at a cost of a return drag in equity up-markets that cross-asset trend can help offset. Active long volatility has historically generated negative returns⁸when equity markets posted large positive returns, while cross-asset trend has generated positive returns in the same environments. In Exhibit 3 below, we analyze the monthly performance of active long volatility and cross-asset trend⁹ from 2005-2023, and we divide the data into three groups based on global equity returns being above, below or within a +/-1 standard deviation of its history. We observe strong returns, on average, for both the active long volatility and cross-asset trend strategies in weak equity markets. However, their performances in equity-up markets was different. In strong equity markets, active long-volatility managers generated negative returns whereas cross-asset trend generated modestly positive returns. When combined at 60% cross-asset trend and 40% active long-volatility, the solution provided strong positive returns in poor equity markets and at the same time avoided significant losses in strong equity markets.

Exhibit 3: Monthly average returns of liquid alternative diversifiers across global equity return buckets (2005-2023)