Time to diversify your diversifiers?

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This year, financial markets have displayed somewhat paradoxical behavior. On one hand, there’s endemic investor anxiety. Uncertainty is widespread, high inflation persists, and policy-related questions are many. On the other hand, the US equity market has climbed this year, despite pockets of significant volatility.

Understanding uncertainty

Although US equity markets have been performing well, we believe investors would be remiss not to take a closer look at many of the reasons uncertainty lingers. Early in 2025, the S&P 500 Index, a proxy for the US equity market, saw a several-week decline, during which value fell as much as 20% at the lowest point. Complicating this dynamic was the April announcement of the most protectionist US trade policies in a century. Since then, those tariffs have been rolled back and renegotiated, and markets have recovered, for the time being, at least.

Tariffs are simply one of many policy-related uncertainties investors have to contend with today. Questions over spending cuts, US deficit expansion, and immigration policies, among others, have exacerbated many investors’ sense of unease. At the same time, other warning signs, such as weakening consumer data (e.g., credit card delinquencies), a cooling labor market, and decelerating earnings revisions, have been emerging.

Sticky inflation is also a prevailing market concern. The US Federal Reserve (Fed) and other central banks have indicated that they will have to contend with inflation despite growth risks. What’s more, geopolitical tensions around the world, including wars, elevated tensions in climate-sensitive equatorial regions, and ongoing great-power competition between the US and China, have helped fuel the engine of uncertainty. Should these dynamics persist or worsen, it’s possible risk assets could come under pressure once again (Figure 1).

Figure 1

The current state of the market prompts myriad broader, longer-term questions. For example: Will the trend of US exceptionalism continue? Will the US remain a growth leader among other major economies? Will the Fed and other central banks focus future policy actions primarily on growth (weakness) or inflation (stickiness)? Will investors begin to derisk in the face of uncertainty?

The answers to these questions are yet to be seen, but one thing is certain: Numerous structural forces, such as deglobalization, suggest that economic cycles will oscillate much more, experience higher highs and lower lows, and push markets to extremes in some cases.

What we’re hearing from investors

This year has reminded investors to revisit their capital market expectations and assess whether their current mix of asset allocations can conceivably achieve their objectives given still elevated valuations and the factors driving uncertainty we explored above. One main conclusion from this may be that many portfolios could benefit from alternative sources of return and diversification. Specifically, diversifying hedge fund strategies that aim to deliver a specific and unique outcome have been a major topic of interest in recent discussions.

Importantly, we see strong economic reasons why many investors are either adding or considering adding diversifying strategies, such as hedge funds, to their existing portfolios. Conditions for delivering consistent, uncorrelated, alpha-centric returns have markedly improved while beta-centric returns, especially when adjusted for risk, are in decline. Elevated dispersion and macroeconomic volatility have contributed to these dynamics.

Diversifying your diversifiers

When equity markets fell in 2022, many investors realized bonds aren’t always an effective recessionary hedge, especially in the face of rising and sticky inflation. Thus, finding strategies immune to duration risk that can still deliver the intended diversification benefits can be quite useful. Certain hedge fund strategies may fill this role and expand portfolio diversification effectively. This isn’t to say that bonds shouldn't feature in a portfolio. They should, but we believe that given the return potential, investors may do well to find complements to traditional fixed income.

Key to this is identifying what matters most across these two dimensions — offsetting potentially lower returns or adding protection at the (marginal) expense of some return? Regardless of where investors fall on the return/diversification continuum, we believe diversified, uncorrelated strategies, including multi-strategy and global macro, may be well-positioned to provide tangible benefits and should, in many cases, be a mainstay in investor portfolios, especially in this highly uncertain and turbulent environment.