Diversify Portfolios With Alternatives
Unusually high stock and bond correlations have reduced the diversification benefits of the traditional 60/40 portfolio. Alternatives — with low correlations to traditional assets — can return balance to the 60/40 and may help temper the impact of a potential increase in inflation or volatility to keep portfolios on track.
Abnormally high stock and bond correlations have diminished the diversification benefits of the traditional 60/40 portfolio. And with equity risk now driving volatility, the traditional stock and bond portfolio has become unbalanced.
This instability comes at a tenuous time, just as the Federal Reserve’s (Fed) inflation fight will have to contend with new policies from the Trump administration expected to boost inflation.
We believe 2025’s macroeconomic backdrop will challenge the 60/40 portfolio. And, because the 60/40 is already under significant pressure, the potential for a policy mistake to trigger a drawdown may be even greater.
Adding the following alternative exposures could strengthen these traditional stock and bond portfolios, helping them withstand macro trends:
- Gold offers historically low correlations to traditional assets and a history of resilience in times of market stress.1
- Broad Commodities tend to have a positive relationship to inflation and a low correlation to traditional assets.
- Alternative Defensive Equity Strategies modify equity risk premia to help strengthen drawdown protection while boosting income generation.
How Correlated Are Stocks and Bonds?
Broken out by year, the rolling 12-month correlation of daily returns between global stocks and bonds has been positive for each of the past three years (Figure 1). Since 1995, while the average rolling 12-month return correlation is -10%,2 it has been positive for more than 630 consecutive rolling 1-year daily observation periods — a near record.
Stock Risk Rising to Normal Levels
This lack of diversification is compounded by equity risk dominating the volatility of the traditional portfolio, making the “balanced” strategy vulnerable to equities’ risk profile.
And that equity risk contribution is climbing. Following elevated bond volatility when the Fed was aggressively raising rates, stocks’ contribution to total portfolio risk has returned to its historical average — increasing for six consecutive months.3
If volatility were to spike with stocks driving total portfolio risk, it could increase the 60/40 portfolio’s drawdown risks. In fact, historically, there’s an 84% correlation between the drawdown of stocks and the traditionally balanced portfolio.4 There’s also a historical 98% correlation between stock returns and the 60/40 portfolio’s returns,5 suggesting the traditional portfolio reflects equities’ trends — in all types of markets.
Macro Uncertainty Challenges Traditional Portfolios
In addition to uncertain fiscal policy, the path and pace of the Fed’s rate cuts have become less clear. September’s forecast of eight 25 basis point (bps) rate cuts by May 20256 was cut in half by the end of October, owing to positive economic growth data.7 And following the US election, the market now expects just two more rate cuts by May 2025.
At the same time, many global central banks are seeking to normalize policy amid shifting fiscal plans. The Bank of England (BoE) recently cut rates for the second consecutive meeting but stopped short of signaling faster easing.8 The BoE warned that the new budget from Parliament could drive up inflation by as much as half a percentage point. And political consternation toward the majority parties in Germany and Japan could cloud fiscal policies in those regions.9
Moreover, potential tariffs from the Trump administration could complicate growth and spark inflation on a global basis, forcing policymakers to contend with multiple external fiscal risks. In fact, China has already implemented significant stimulus measures to offset potential economic weakness from US protectionist policies.10
It’s no surprise that policy uncertainty has skyrocketed in response to evolving monetary policy and global fiscal policy positioning for US protectionism. The US Economic Policy Uncertainty Index currently sits at its third-highest reading ever, just behind the COVID-19 pandemic and the Great Financial Crisis (Figure 2).
Can Real Asset Alternatives Deliver Durable Diversification?
Strengthening the 60/40 portfolio in an ambiguous macro environment requires adding strategies that are less correlated to traditional markets with differing macro sensitivities to growth and inflation, to bolster the portfolio’s foundation and boost resilience.
In addition to increasing diversification, alternatives like gold, Treasury inflation-protected securities (TIPS), commodities, infrastructure, natural resources, real estate, and digital assets — added individually or grouped together as part of a multi-asset real return strategy — may help hedge inflation volatility.
Given that equity volatility tends to be asymmetrical — meaning volatility rises more quickly in response to stock prices falling than it falls in response to stock prices rising — gold may help mitigate equity volatility jump risk in the event of a policy mistake.
Historically, when the CBOE VIX Index (VIX) has spiked, gold has had strong returns relative to other asset classes (Figure 3), especially when volatility increased beyond three standard deviations.
Gold also may help hedge the risk of the growing federal budget deficit. It’s estimated that Trump’s policies could add $7.5 trillion to the national debt over the next decade.11 A wider deficit also will likely spur more gold demand from central banks to diversify their reserves.
Inflation is the more immediate macro risk in 2025. Inflation trends will have to contend with a healthy consumer, potentially disrupted supply chains from tariffs, retaliatory tariffs, as well as ongoing global conflicts in commodity-rich regions. As St. Louis Fed President Alberto Musalem said following the election results, “The risk of inflation ceasing to converge toward 2%, or moving higher, has risen.”12
In addition to sharing gold’s noncorrelation to traditional assets (Figure 4), commodities have historically had a strong sensitivity to both rising and unexpected inflation.13
From an implementation perspective, as a more natural diversifier to equities, gold portfolio additions should be sourced from bonds. Meanwhile, given inflation is a risk that nominal bonds don’t handle well, additions of commodities to the 60/40 portfolio to diversify bonds should be sourced from the equity allocation.
Alternative Defensive Equity Strategies: Guarding Against Drawdowns
Derivative-based defensive equity strategies that transform beta risks by selling calls have historically helped guard against drawdowns.
Covered call strategies’ defensive properties stem from selling away upside in lieu of a premium. And that collected option premium acts as a buffer in downward trending markets, reducing downside capture. The more market-aware a covered call strategy is, the greater likelihood it can adapt to changing market regimes without sacrificing upside.
For example, relative to the market, an indexed market regime-aware covered call S&P 500 exposure has historically had 15% less volatility, 23% lesser average drawdowns, and captured just 62% of the market’s downside moves over the past 35 years.14 And the more market-aware indexed covered call strategy has outperformed the more naive and static 2% out-of-the-money version by 80 bps per year over the past 35 years.15
With this in mind, an active covered call strategy that combines a fundamentally built underlying equity portfolio with a dynamic options overlay could potentially improve upon a non-market regime aware and static indexed covered call strategy — while seeking to offer alternative forms of drawdown protection amid macro uncertainty.
Implementation Ideas
The abnormally high correlation between stocks and bonds combined with equity risk driving volatility have destabilized portfolios. Consider adding alternatives with lower correlations to traditional assets and greater drawdown protection and income generation to restore balance.
Gold
Broad Commodities
Alternative Defensive Equity Strategies
