How to Identify True Diversifiers

With the notable exceptions of investment-grade debt and managed futures, the correlations are rather high in the context of the math we just laid out. Now, that can't be applied directly to any pair of assets in this matrix because these assets all have different volatilities, but with the full admission that this is an oversimplified exercise, a back-of-the-envelope analysis would suggest that many "diversifying assets" don't reduce volatility all that much. The takeaway is that those few assets that are truly uncorrelated are hugely valuable to a portfolio.

Historically, bonds have played the role of the uncorrelated asset, and they have done an admirable job. But volatility reduction is only part of the equation; an asset class or strategy must have a meaningfully positive real return expectation to warrant inclusion in a portfolio. With the 10-year Treasury at 1.78% as of April 4, well, you get the picture.    

True diversifiers are rare, but as the correlation chart reveals, there is another option beyond investment-grade debt, one with arguably better expected returns at this point – managed futures. 

There are many strategies that fall under the managed futures label, with the most common approach being trend following; that is, buying assets that are trending higher and shorting assets that are trending lower. The primary differences among trend-following strategies are the asset classes that are traded and the durations of the trends that managers are attempting to capitalize on. But there are other approaches within the category as well, such as short-term counter-trend strategies. To be clear, counter-trend trading models are not the opposite of trend following, rather they are indifferent to longer term trends. Counter-trend models offer a systematic approach to sell short-term overbought levels and buy short-term oversold levels. This mean-reverting behavior allows counter-trend models to thrive in markets with a lot of back and-forth price movement.    

Importantly, while both trend following and counter-trend strategies can be effective in their own right, it's worth noting that in addition to being uncorrelated to traditional assets, these disparate approaches to managed futures tend to be uncorrelated to one another. As we've demonstrated, most investors can use all the uncorrelated assets they can get.   

— Read "Where to Invest if Interest Rates Go Negative" on ThinkAdvisor.