New directions in diversification: Four ideas for a shifting economy

The decade that followed the 2008 global financial crisis was a period of relative calm for the economy and the markets. By now it’s clear we’ve moved beyond that, with policy decisions in recent years and their economic effects having planted the seeds of a more volatile future. In addition, as we’ve seen in the Middle East this month, higher levels of geopolitical turmoil are adding to the volatility.

I think these shifts point to a future in which the traditional rules of diversification won’t always apply and that investors should prepare for it by taking a broader view of diversification to help build more resilient portfolios.

What’s changed and why it matters

In recent years, there has been a reversal in the globalization trend that dominated the 20th century. We’ve seen trade barriers rise and supply chains fragment. This, in turn, has brought about greater dispersion in the policy responses of different countries (e.g., less synchronized interest-rate policies and varying levels of fiscal stimulus) and in their economic outcomes.

As our macroeconomics team has argued, all of this is likely to add up to less stability in the economic cycle. Since the mid-1990s, the global economy has mostly been in a “Goldilocks” environment of positive growth and low inflation. But going forward, we may see the economy move more rapidly between phases of the cycle, including periods of more inflationary growth and recession.

The inflation point is critical: Investors have long relied on the negative correlation between stocks and bonds for diversification purposes (i.e., when stocks have struggled, bonds have helped cushion the blow). But higher inflation can contribute to positive stock/bond correlations, as it tends to push interest rates up and bond prices down, while simultaneously eroding equity valuations and challenging margins.

I’m not suggesting that fixed income will never provide protection in an equity sell-off, but the possibility that it will do so less consistently is one key reason to review current portfolio allocations and seek out untapped sources of diversification.

Where to start the search

I think investors looking to build more resilient portfolios should explore four options:

1. Hedge funds
Returns from some categories of hedge funds may be uncorrelated to traditional assets — in part because the funds lean on active risk rather than market risk, making them a potentially attractive “all weather” complement to a typical stock/bond portfolio. For example, multi-strategy funds generally maintain little or no directional exposure to equity markets, which may help insulate them from big market drawdowns. These funds combine a range of hedge fund strategies, such as macro, long/short equity, and long/short credit, in pursuit of a more stable risk and return profile. They may include a wide array of independent, specialized risk takers; invest in distinct asset classes; and combine systematic and fundamental investment processes. By combining strategies and tightly managing their aggregate risk, multi-strategy funds create the potential to provide considerable portfolio-level diversification.

Given the likelihood of greater economic and market volatility today, I think investors might also consider complementing their traditional equity exposure with equity long/short hedge funds. While these funds do have directional equity exposure, they typically have much less than a traditional “long-only” equity investment. They often have dynamic exposure to the equity market, allowing the manager to reduce exposure in an effort to protect capital during a sell-off.

My colleagues and I discuss these ideas in greater detail in our paper, Are hedge funds the missing ingredient?

2. Inflation-hedging assets
As the new economic environment that I described above was emerging a few years ago, higher inflation returned after a long absence, and it caught many investors off guard. While central banks have made some progress tamping down inflation, they may be in for a long fight, with a variety of factors, including tight labor markets, rising government deficits, and underinvestment in commodity production, contributing to upward pressure on prices.

Given how challenging it can be to forecast inflation, and especially when economic and geopolitical conditions are so unsettled, I think this is a good moment to consider adding diversifying assets that are more sensitive to changing/rising inflation. Asset classes typically found in “real asset” or inflation-hedging strategies include commodities, natural resource equities, inflation-linked bonds, real estate, and infrastructure assets. Historically, many of these asset classes have had positive performance in periods when stocks and bonds have fallen in tandem (e.g., during periods of rising inflation).

3. Defensive equities
Defensive equity strategies, which invest in companies that tend to provide consistent earnings and dividends, may add some stability to a portfolio. They often have lower equity beta (market sensitivity) and can help limit exposure to market downturns, even if they lag a bit in strong market upturns. (Importantly, even though markets typically go up more often than they go down, many defensive strategies have added value across a full market cycle — the value of “cutting off the tails” of market sell-offs can be very powerful.)

Recently, defensive equities have been out of favor as they’ve underperformed in a market focused on growth and the technology sector in particular. But even if technology maintains its leadership position for some time to come, I think defensive equities have a role to play in a portfolio and could outperform over the long term. And given their recent struggles, this could be an attractive entry point for investors.

On a related note, our equity strategist, Andy Heiskell, has pointed out that rising equity market concentration has resulted in investors in a nominally “broad” equity index fund, such as one tied to the MSCI All Country World Index, actually holding significant exposure to US stocks and the mega-cap technology names that have led the market. With that in mind, another way to diversify may be to hold more exposure to non-US equities, including emerging markets. (But, as I have written about elsewhere, investors should be deliberate about sizing this type of exposure, in case the current technology cycle persists.)

4. Dynamic fixed income
Even if there are times when fixed income may not be an effective counterweight to equity risk, the asset class will continue to play a key role in portfolios. In the current environment of relatively tight spreads and low interest rates, I think investors should look for opportunities to increase portfolio dynamism in fixed income. This may include total return strategies, multisector strategies that seek to add value through sector selection/rotation, opportunistic strategies that focus on out-of-favor sectors due for a recovery, and fixed income hedge funds.