How diversified is your portfolio?

Protection through diversification is crucial to any investment strategy. But ever since the global financial crisis 11 years ago, true diversification has been harder to find.

True diversification goes beyond investing across traditional asset classes; it actively seeks to protect your portfolio from downside risk throughout the investment cycle. Simply holding a range of asset classes does not necessarily protect a portfolio from market downturns. These asset classes are often correlated to the broader market and one another.

The chart below shows the correlation of traditional asset classes with the S&P 500 before and after the global financial crisis. A correlation of 1 would mean it is totally in sync with the S&P, while a correlation of less than zero would mean it is inversely correlated (i.e. it would move in the opposite direction).

In the years preceding the global financial crisis, a portfolio containing international (ex-US) equities, investment grade and high yield bonds, REITs and commodities could have provided genuine diversification. With the exception of international equities, the correlations of these asset classes with the S&P were less than 0.5. In the case of US investment grade bonds, the correlation was negative.

Post the global financial crisis, correlations of all these asset classes to the S&P 500 have risen. For US investment grade bonds, REITs and commodities the increase in correlation is significant. If your portfolio, or your client’s portfolio looked like this, just how diversified would it really be?

That’s why we think that investors looking for true diversification should consider allocating a part of their portfolio to liquid alternatives.

Liquid alternatives can provide access to hedge fund strategies through a regulated product structure. The chart above also shows that correlations of certain hedge fund strategies have reduced since the global financial crisis.  

Protecting yourself from market downturns  is crucial to long-term investing.  A portfolio of highly correlated assets will not necessarily provide protection during these downturns. Adding liquid alternative strategies to a portfolio can reduce correlations and allow a better navigation through challenging periods.