When we are designing portfolios, diversification (aka correlation) is what it all comes down to.
In a nutshell, correlation measures the strength of the relationship between the returns of two investments: For example, how two asset classes such as U.S. stocks and Treasury bonds move together. Perfectly correlated investments – often rated as +1 – will always increase or decrease in value at the same time and at roughly the same rates. On the flipside, two negatively correlated assets will always move in opposite directions. If you hold a portfolio of 40 different asset classes and their correlations are similar then it really doesn’t matter that you hold a diverse basket of assets.
Real diversification means that your portfolio’s holdings move in different directions and magnitudes under various conditions. The idea is that while this can’t guarantee zero losses, it does help impact longer-term returns in a positive way. Losses in foreign stocks are buffered by gains in gold, for example.
The problem is that traditional asset classes used for diversification are now getting more and more correlated. Stocks and bonds are moving in the same directions as low interest rates switch up the relationship. A more interconnected global economy is limited by the effect of holding international stocks. Even commodities and real estate assets aren’t producing the same level of non-correlation that they once did.
Which is why, investors – especially institutional ones – have been drawn to alternatives. Retail investors may not be familiar with strategies like 130/30, market neutral, event driven or merger arbitrage, but these techniques could be key in solving the diversification dilemma. These strategies have been packaged into mutual funds, ETFs and other vehicles, and also dubbed as liquid alternatives.
While a long-short credit fund is really a separate asset class, in this context it can be still considered as a bond. The strategy tends to produce uncorrelated returns; as does the rest of liquid alts. This allows them to be powerful and attractive diversifiers for portfolios. You can see that from this chart by asset manager Mackenzie.