“It takes every kinda people
To make what life’s about, yeah
It takes every kinda people
To make the world go ’round”
– (From “Every Kinda People,” by Robert Palmer, 1978)
By Scott Welch, CIMA®, CEPA®, Chief Investment Officer & Partner
Reviewed by Carter Mecham, CMA®, IACCP®
Let’s face it – diversification within an investment portfolio is a lot harder than it used to be. As more assets become tradeable via securities on an exchange, the diversification benefits of those underlying assets tends to decrease.
The correlation between the price movements of different strategies is one way of measuring the diversification benefit of those strategies. As a reminder, correlation is a statistical measure of how two investments move relative to each other over time.
The correlation between asset classes, styles, and strategies can range between “+1” (very tight correlation – the investments tend to move in tandem over time) and “-1” (inverse correlation – the investments tend to move in opposite directions over time).
Perhaps counterintuitively, it is not necessarily desirable to pair strategies that are perfectly negatively correlated, as that means when one strategy is winning the other is probably losing, making it difficult to generate positive performance over time.
Rather, strategies with correlations closer to zero provide better diversification benefits within an overall portfolio. So, a strategy with a closer-to-zero correlation to another strategy is a better diversifier than one with a -1 correlation.
As a simple example, let’s take a “building block” approach to building a diversified portfolio.
First, we look at the US taxable bond market. We see some diversification benefits based on duration (maturity) and some, but not much, by diversifying across credit sectors.
Source: Morningstar 2026 Diversification Landscape, April 2026. You cannot invest in an index, and past performance is no guarantee of future results.
Now take a look at the current correlation matrix of the primary US equity asset classes and styles. Not much diversification is available anywhere within the US equity market.
Source: Morningstar 2026 Diversification Landscape, April 2026. You cannot invest in an index, and past performance is no guarantee of future results.
If we expand this to include non-US markets, we still do not see significant diversification benefits within the global equity spectrum (with the slight exception of Emerging Markets).
Source: Morningstar and VerdadCap.com, as of August 2026. You cannot invest in an index, and past performance is no guarantee of future results.
What about if we include bonds, real estate, commodities, and hedge funds? Here we begin to see the ingredients of a more truly diversified global portfolio.
We’ve highlighted the asset classes with correlations of roughly 0.50 or below (better diversifiers) in green, and higher correlations (worse diversifiers) in red. We use the HFRI composite index as a proxy for a broad allocation to alternative or non-traditional strategies (hedge funds).
Sources: Morningstar, Wilshire, and the HFR Index Family, as of August 2026. *The HFRI correlations are approximate using publicly available information. You cannot invest in an index, and past performance is no guarantee of future results.
What about diversifying across different alternative strategies themselves? Several strategies (equity long/short, equity hedged, relative value, etc.) have higher correlations to the equity market but, in general, many hedge fund strategies exhibit lower correlations not just to the broader US market but also between themselves.
In particular, “systematic trend” strategies, also known as managed futures, as well as equity market neutral strategies, show low correlations to almost every other alternative strategy, and to the broad US equity market as well.
Source: Morningstar 2026 Diversification Landscape, April 2026. You cannot invest in an index, and past performance is no guarantee of future results.
This is a good argument for including non-traditional or “hedge fund” strategies within an overall portfolio (keeping in mind that these strategies are available in other structures besides hedge funds, such as mutual funds and ETFs).
For many investors, an appropriate approach is to deploy multi-strategy funds or Funds of Funds versus trying to build a diversified alternatives portfolio with individual funds (which can require very large portfolio sizes).
Regular readers know we are believers in diversifying across both asset classes and risk factors, as we believe that has the potential of improving the consistency of performance over full market cycles.
If we turn our attention to the correlations between the primary risk factors, what we see is the benefit of diversifying across risk factors versus the benefit of any one factor to the broader US market.
Source: Morningstar 2026 Diversification Landscape, April 2026. You cannot invest in an index, and past performance is no guarantee of future results.
One of the challenges of creating a diversified portfolio is that correlations are not static – using “point in time” correlation matrixes such as the ones illustrated above are a useful starting point, but no investor should expect that correlations will remain constant over a full investment cycle.
We can see this illustrated by examining two simple time series of the correlation between stocks and bonds – two asset classes that historically have been viewed as “natural hedges” to each other.
What we see is that sometimes that is true and sometimes it is not.
Source: JP Morgan “Guide to the Markets,” as of August 31, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
Source: The Financial Times and The Daily Shot, as of September 1, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
We witnessed this loss of diversification benefit first-hand during the “Dot.Com” bubble of 2000-2002, the Great Financial Crisis o0f 2008-2010, and the COVID pandemic of 2020-2022 (highlighted in the shaded areas in the below graphs) when the correlations between a variety of different asset classes and risk factors all approached +1 – that is, failing to provide appropriate diversification just when it was needed most.
Source for the previous four charts: Morningstar 2026 Diversification Landscape, April 2026. You cannot invest in an index, and past performance is no guarantee of future results.
This final chart illustrates why alternative strategies fell out of favor with many investors during the decade of 2010 – 2020. We lived through ten years of “ZIRP” (Zero Interest Rate Policy). Quantitative Easing (QE), and Fed “forward guidance,” all of which correspondingly drove low interest rates and low market volatility – difficult conditions for any non-traditional investment strategy, which historically perform best in market environments characterized by rising interest rates and higher volatility.
Source for the three previous charts: JP Morgan’s “Guide to Alternatives,” as of July 31, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
So, during that 2010-2020 decade, not only did these strategies not deliver impressive performance numbers, but they also did not provide the expected diversification benefits.
The correlation levels for alternative strategies after 2023-2024, however, illustrate why these strategies have regained favor in today’s market environment.
What About Private Markets?
Some investors believe that private markets can be an important source of diversification within portfolios, but there are nuances that must be highlighted before making this determination.
A cursory glance at the private markets might suggest diversification benefits because they often post lower volatility metrics than public markets. But it is a mistake to take these metrics at face value.
By definition, these investments are privately held by institutional and individual investors, and as such are not required to and do not engage in daily mark-to-market valuations.
Private market returns are usually calculated as an Internal Rate of Return (IRR), Multiple of Invested Capital (MOIC), and/or appraisal-based valuations. There is nothing wrong with these metrics, but they do result in differences with public market valuations (and, thus, potential diversification benefits).
One characteristic is known as “appraisal smoothing,” whereby private investments are only valued or “marked” on a quarterly basis rather than daily. This artificially dampens or “smooths” the measured volatility of the underlying investment, which can, in turn, make reported correlations with public markets seem lower than they actually are.
Another issue is that of stale pricing. Because private investments are often marked only quarterly, investors may be comparing lagged private market pricing with current (daily) public market pricing.
We can try to solve for these issues using publicly available private market benchmarks, such as those provided by institutional data providers and consultants. These are useful but keep in mind that they typically represent composite compilations of multiple funds that may or may not be comparable to an investor’s actual allocations.
Furthermore, using these benchmarks can lead to “provider dependency” – the results you get depend on which provider you use for the data.
But we can use them as a starting point.
Source: KKR Global Wealth, “Private Infrastructure: An Asset Class for All Economic Conditions,” January 2025.
Source: Preqin Insights+, “Preqin’s State of the Market: H1 2025” (January 2025), Paul Sinthunont & Salik Ahmed — Exhibit “Private capital and public market return correlations,” p.24. Indices: Preqin Private Equity, Preqin Private Debt, Preqin Real Estate, Preqin Infrastructure (all net of fees), vs. S&P 500 Total Return (TR), Bloomberg Global Aggregate Corporate TR, Bloomberg Global High Yield TR, and Bloomberg Global Treasury TR.
What we notice in both of these correlation matrices is that Corporate and Sovereign bonds seem to provide the best diversification benefits to other asset classes. The private markets may provide some degree of diversification benefit, but with the measurement and reporting caveats highlighted above.
We believe that private investments should be viewed primarily as potential sources of diversified return, not necessarily as drivers of lower portfolio volatility.
Private equity is still equity, private credit is still credit, and private real estate is still real estate. The nature of the investment structures, the use of illiquidity and leverage, and different underwriting characteristics may make private investments important sources of potential excess return, yield, or inflation protection, but we would suggest taking any purported portfolio diversification benefits with a large grain of salt.
Summary and Interpretation
We believe in portfolio diversification at both the asset class and risk factor levels – we believe the combination of the two may result in better overall diversification and, therefore, more consistent portfolio performance over time.
We include in this portfolio allocation prudent use of alternative or non-traditional investment strategies, which the industry sometimes (simplistically) refers to as hedge funds (these strategies are also available in mutual fund and ETF structures).
These include strategies like hedged equity, long/short equity, managed futures or trend-following strategies, global macro, event-driven, market neutral, as well as multi-strategies or Fund of Funds that incorporate a variety of strategies into a single investment vehicle.
This improved diversification has the power of potentially improving investor discipline during market disruptions and also allows the power of compounding to work – if you don’t lose as much in a down market you do not need to make as much in an up market to still come out ahead over a reasonable investment horizon.
Source: Derived using Excel and appropriate calculations / formulas. For illustration purposes only and does not represent investment advice.
Source: Gilbert Wealth, July 2023. For illustration purposes only.
We also believe in the inclusion of private market investments for those investors who can access them and understand the characteristics of these types of investments. That said, we include these investments in our portfolios for potentially enhanced growth, yield, or inflation hedging purposes – not necessarily for diversification purposes.
We return to our recurrent theme of “economic regime” investing, whereby we believe the economy is continuously “flowing” through periods of rising or falling economic growth and inflation.
We then overlay onto this the types of investment strategies that typically perform better in each “quadrant”.
Source for both charts: Certuity. For illustration purposes. Does not represent investment advice.
We define each investment strategy as:
- Capital Growth: Public and private equity
- Income: Public and private credit and other yield-generating strategies
- Real Assets: Real estate, MLPs, commodities, precious metals, and so forth
- Diversifying Strategies: Alternative or non-traditional strategies (i.e., “hedge fund” strategies)
Since we believe philosophically it is very difficult to time the markets and that correlations between asset strategies are not static but rather vary over time, we believe the best approach is to build strategic portfolios that are widely diversified across all these categories and may therefore perform consistently over full economic regime and investment cycles.
This is not a “set and forget” approach – market and economic conditions can and do change and we need to be responsive when necessary.
But we believe this strategic framework is a solid starting point, and we tend to be “patient” investors who respond to fundamental market signals and not to the inevitable periods of market disruption and noise.
As always, we welcome your questions and feedback.