Years after the global financial crisis, the advisory community continues to grapple with portfolio diversification. Fortunately, the increased availability of alternative mutual funds means that advisors have new diversification tools available to them.
Viewed individually, each alternative asset classes presents what is known as a bi-modal distribution of data. These bi-modal distributions confirm that the correlations of these asset classes to the broader market vary depending upon market conditions — they're often non-correlated in rising markets, but highly correlated in falling markets — creating a diversification trap just when investors need the benefits of diversification the most.
To mitigate the risk that diversification traps pose on a portfolio, advisors may consider the use of an equity market-neutral strategy, which seeks to limit portfolio exposure to the overall market. According to Morningstar, Inc., market-neutral is "one of the only strategies that actually exhibits low correlation, and therefore, true diversification, by mandate."
Due to their portfolio construction, market-neutral strategies are designed to limit exposure to volatility and movements of the traditional equity and fixed income markets potentially mitigating the impact that large market draw-downs have on a portfolio. This should result in returns that are generated independent of these markets, which may result in a more stable portfolio return profile due to lower volatility and lower correlation relative to other investments.
Because of this tendency to stabilize the return stream of a balanced portfolio, a market-neutral strategy also may help to reduce the psychological toll that returns achieved through volatility inflict on investors.
