Can bonds be relied upon to diversify stocks in years to come, as they have for most of the new millennium? The spike in correlation between equities and fixed income seen in June last year, and the possibility of a return to the positive correlation of the 1990s, make the question a pressing one.

Investors have been forced to rethink many things in the post-crisis years. Given the dislocations seen when the US Federal Reserve signalled a wind-down of monetary stimulus last year, and the temporary retreat from risk assets in early 2014 as the Fed’s pullback got under way, it’s clear that the rethinking should continue. The fault lines extend across the global investment landscape, intersecting with other market-shaping policy trends, making it hard for investors to rely upon prior assumptions about some of the most basic elements of investing.

How best to hedge risk and achieve returns when so many familiar tools and strategies aren’t working as they once were? In concept, the answer is as simple as it is by now familiar: diversify. Cast a wider net. The challenge, of course, is casting the net successfully in a fast-changing world. It’s an effort that calls for a balanced approach, combining an awareness of the current landscape, a focus on desired outcomes, and ability to judge individual strategies not in isolation but in terms of their impact on the overall portfolio.

Getting real

A desire for additional diversification may be one reason for the strong interest in real estate and real assets expressed by nearly 100 clients representing approximately $6 trillion in AUM in our Global Survey of Institutional Investors, conducted at the end of last year and released in January 2014.

Real estate’s record of low correlation with bonds and equities is well established. Of course, investors look to real estate for other qualities as well. In the years following the financial crisis, cautious investors focused on income-producing core investments. More recently, some have shown renewed interest in generating higher returns via value-added and opportunistic strategies, often outside their home markets.

Investments in infrastructure assets provide diversification because of their unique physical, economic and financial characteristics. These hard assets (power plants and toll roads for example) provide essential public services and generate predictable cash flows via their long-term contracts, licensed monopoly status or regulatory protection.

Infrastructure debt diversifies a credit portfolio by virtue of being secured and serviced by hard assets, unlike most corporate bonds of comparable credit quality. Long maturities match up well with the liabilities of many investors, the risks are often different from the ones investors face elsewhere in their portfolios, and the illiquidity is still well rewarded. Moreover banks, especially in Europe, are pulling back from their traditional role in funding the sector, resulting in a significant funding gap – and an attractive debt investment opportunity.

Seeking returns and diversification

As always, investors must look partly to equities to drive growth in their portfolios. But after unusually strong equity returns in 2013 – a 23 per cent gain for the MSCI ACWI – differentiation and diversification count more than ever.

• To broaden the base of potential growth drivers, alternative investments offer a number of options. Some of the most promising involve opportunities created by another facet of European bank deleveraging: sales of assets, many of them distressed. Hedge fund strategies targeting these sales continue to look like a good potential source of return.

• In equity index strategies, going global is one means of broadening the base – the MSCI ACWI IMI (All Country World Index Investable Market Index) is the fastest growing industry strategy.

• Emerging markets remain a long-term diversifier for index investors, despite recent turmoil as markets adjust to the withdrawal of monetary stimulus in the US and frontier markets can also provide further diversification.

• Moving beyond market-cap weighted indices is another path to diversification. Strategic beta vehicles – including minimum volatility, fundamentally-weighted and factor-based index strategies – are the solutions here.

The need for diversification in fixed income was driven home for many investors in 2013, when the Barclays US Aggregate Index posted a negative return for the first time since 1999. However, during the 2008-2009 financial crisis, EM debt was one of the few sectors in the global financial market to show resilience. The rise of these markets has given asset allocators a new set of tools to work with, enhancing their ability to construct portfolios that offer better risk-adjusted returns. Although correlations tend to be high between EM equities and fixed income, investors are starting to find new opportunities to diversify across asset classes and local markets.

The multi-asset approach

The push for portfolios better able to deliver desired outcomes over time is leading many investors to consider flexible, multi-asset strategies. These strategies take different forms but all have diversification in their DNA and entail reaching across asset types and geographies for attractive opportunities.

Many multi-asset strategies seek to use the power of diversification to lower volatility. If drawdowns can be minimised, investors have a better chance of reaching their goals. Simple maths shows that a portfolio that loses 50 per cent in one year needs a 100 per cent return the following year to make up the lost ground. To repeat a timeless truth, compounding – both negative and positive – is a major factor in investment results.

The heart of the argument is the ability of a multi-asset strategy to apply a common framework across the different asset classes employed, from debt and equity to commodities, real estate, currencies and beyond. Choosing to allocate to these areas is merely a first step. Achieving the well-calibrated diversification needed to move toward a desired outcome requires an ability to look more deeply at the underlying factors driving asset performance and manage those exposures in a holistic and dynamic way.

Outcome orientation

When longstanding approaches to investing start falling short, a logical response is casting a wider net. But taking up new tools and strategies (to say nothing of integrating them with existing ones) isn’t easy. In fact it is anything but, and requires roughly equal measures of open-mindedness, flexibility and scepticism. Asking hard questions is a key part of the process.

The rethinking investors must do needs to be both broad and deep. Ultimately, though, it’s about putting any newly proposed tool to a straightforward test: is it likely to move the investor closer to a desired goal? Outcomes aren’t just the focus for multi-asset strategies. They are the star to steer by in a changing world.

Charles Prideaux is head of the EMEA Institutional Client Business, BlackRock

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