In recent years a number of investors realized they weren’t really diversified with a traditional stock and bond portfolio. So, they started to add other assets and strategies. But once the Fed started manipulating markets with quantitative easing, the diversification of many of these investments disappeared. Morningstar recently revisited some of the more popular diversifiers to see if their portfolio benefits increased. The conclusion is that it’s a mixed bag. You should expect that. Correlations between assets change over time, and over short time periods they don’t mean much. Also, when the Fed tightens money, most assets tend to decline in value and only cash is attractive to people.
In assessing diversification benefits, I subjected each asset type to a two-part test: 1) overlap factor–that is the extent to which the asset is likely to appear in diversified funds investors already own–and 2) diversification benefit, as measured by each investment’s correlation coefficient relative to other widely held asset types. (We plan to incorporate correlation data into Morningstar.com in the future, but right now it’s only available in Morningstar’s Direct software.)
In testing the correlations, I used a combination of indexes and fund categories, generally opting for the one with the longest observable track record. Note that as with any exercise that relies on past performance, what has been correlated–or not–in the past may not hold up in the future.