Rising Correlations: Why Investors Should Consider Alternatives

TL;DR: Rising correlations were observed in recent years between traditional asset classes (bonds and equities), across geographies, within asset subclasses (e.g., small-cap and large-cap equities), and even between indices and some commodities. This decline in diversification should push investors and asset managers to explore alternative assets.

Long version: For the past two decades, investors were able to diversify within the traditional realm of asset classes: bonds served as a hedge against stock market volatility, providing protection during downturns. However, this dynamic has shifted, with correlations between bonds and stocks turning positive, especially during inflationary periods.

From 1970 to 1999, the correlation between stocks and bonds averaged 0.35—slightly positive. But from 2000 to 2022, the correlation turned negative, allowing bonds to act as a reliable hedge. This was largely due to low inflation and counter-cyclical central bank policies. However, since 2020, high inflation has caused stocks and bonds to move in the same direction again (correlation was 0.6 b/w stocks and mid-term government bonds for 12-months until April 2024 as per Morningstar). The classic 60/40 portfolio lost 17% in 2022, demonstrating that it’s no longer a one-size-fits-all solution.

With bonds no longer offering the same protection, alternative assets (most known examples are real estate, private equity, and hedge funds) are becoming essential for portfolio diversification. They often have low or negative correlations with traditional investments, providing a buffer during market stress. For instance, real estate and infrastructure offer stable, inflation-adjusted income streams, making them valuable during periods of rising inflation and interest rates. Private equity and hedge funds also employ strategies uncorrelated with public markets, such as long-short, event-driven and arbitrage approaches.

Recently, however, even traditional commodities like gold have been moving in line with major indices like the S&P 500. This suggests the need to explore other, more complex options. We believe fund managers will increasingly adopt specialized strategies to avoid competition and offer better products that are less correlated with general markets. Examples include movie royalties, wine funds, litigation finance, and trade finance.

Investors, in turn, will feel the need to rethink their portfolios and consider alternative assets to achieve better diversification. 

Sources used: CFA Institute Blog (picture below), AQR Capital Management, Robeco, Alpha Architect

Correlations between asset classes through time: