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Diversification and Bonds: Your Portfolio’s Hidden Risk

July 2023
Key Takeaways
Bonds play a crucial role in diversification, but their positive correlation with stocks poses a hidden risk—compromising traditional diversification benefits.
Given these uncertain dynamics, relying solely on bonds for balance may not be prudent.
Incorporating a sleeve of low-correlating assets can potentially improve portfolio diversification and risk management across multiple market environments.

While advisors may be cautiously optimistic about elevated bond yields, it is crucial to consider the other important reason for investing in bonds beyond return and income, and that is diversification. Bonds have historically played a significant role in diversifying portfolios, which has led to reduced overall volatility, and has been a hedge against equity market fluctuations. In the current landscape, where bonds and stocks are experiencing a period of positive correlation, it becomes even more important (if not critical) to incorporate additional diversification strategies to help mitigate portfolio risk and preserve portfolio balance.

In this article, we delve into the historical role of bonds for potential return and diversification benefits, the impact of changing dynamics on bonds’ ability to deliver on these expectations, and the importance of including additional diversifiers to possibly help compensate for periods of positive correlation (which happen more often than you think). We also explore the potential benefits of incorporating a sleeve of low-correlating assets to help reduce risk and enhance reward in portfolios over multiple market cycles.


The Historical Role of Bonds

By examining bonds’ historical return profile, we can understand the significant contribution bonds have made to overall portfolio performance both in the short and long term. One of the key benefits of bonds is their ability to generate income, historically making them a reliable source of cash flow. Additionally, bonds have the potential to appreciate in value when interest rates decline.

Another potential advantage of bonds is their role in diversification and risk reduction. Traditionally, bonds have shown negative correlation with stocks, meaning they often move in the opposite direction. This inverse relationship has helped to stabilize portfolios during equity market downturns, which has provided a buffer against losses.

This potential combination of stability, capital appreciation, and diversification makes bonds a valuable component of a well-rounded investment portfolio.

Changing Dynamics and Positive Correlation

The dynamics between stocks and bonds, however, have evolved in recent times. Likely a hidden risk to many investors, we examine the challenges of positive correlation between stocks and bonds and its implications for diversification. Positive correlation implies when stocks rise, bonds also tend to rise, and vice versa. Positive correlation regimes disrupt the traditional diversification benefits of bonds, and during such periods, investors effectively hold a long-only portfolio. An unintended risk.

Stock and Bond Correlation* – Negative and Positive Regimes

1/1/1960 – 3/31/2023

As advisors understand the need for diversification, it is vital, therefore, to recognize the limitations of relying solely on bonds for balance across all time periods. To offset the inconsistent diversification value of bonds, we believe alternatives, or low-correlating strategies, should be explored.

Enter the Concept of Low-Correlating Assets

Low-correlating assets exhibit a lower or non-existent correlation with traditional asset classes like stocks and bonds. By incorporating low-correlating assets into portfolios, investors can potentially achieve improved diversification and risk management, even when stocks and bonds move in tandem.

Understanding Correlations among your Core Holdings

Correlation ranges on a scale from 1 (perfectly correlated) to -1 (inversely correlated). For advisors whose primary objective is diversification, an optimal correlation value might range between -0.5 to 0.5. Anything below -0.5 has high inverse correlation and anything above 0.5 could move too closely in tandem with equity markets. The objective of diversification is to find strategies that move independently, but not necessarily inversely.

By incorporating low-correlating assets into portfolios, investors can potentially improve diversification and risk management, even when stocks and bonds move in tandem.


Balancing Risk and Reward with a Sleeve of Low-Correlating Assets

To achieve a better alignment between risk/return objectives using low-correlating assets, we believe combining two or more of these low-correlating strategies into a portfolio, creating what is known as a “sleeve”, can be an effective way to diversify a portfolio.

A sleeve strategy involves the creation of a separate allocation within the portfolio specifically dedicated to low-correlating assets. By doing so, investors can potentially mitigate risks associated with traditional asset classes and the periods of positive correlation to improve diversification. This strategic approach helps balance the risk and reward dynamics, potentially providing a more stable foundation for long-term investment success.

Performance Analysis:
Evaluating Portfolios’ Risk and Return Characteristics With and Without the Sleeve Strategy

1/1/1980 – 12/31/2022

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Selecting Low-Correlating Assets

The success of a sleeve strategy relies on selecting low-correlating assets to complement the existing portfolio. These assets can vary widely and may include alternative strategies such as bond alternatives, commodities, or strategies like managed futures. Targeting desired outcomes for sleeve composition allows investors to tailor their portfolios to specific risk profiles and investment objectives—such as hedging inflation, or capturing additional return sources, for example.


Diversification remains a fundamental principle of portfolio management, particularly in an increasingly uncertain market landscape. While bonds continue to serve an essential role in portfolios, their potential diversification benefits can be undermined during periods of positive correlation with stocks.

An alternative sleeve strategy may provide a compelling solution by incorporating low-correlating assets with the potential to enhance risk management, reduce portfolio volatility, and improve long-term performance.

To successfully navigate the future, investors and advisors must adapt their investment strategies to manage risk more effectively and to achieve their financial goals, regardless of the market environment. By evolving portfolio construction beyond traditional investments such as stocks and bonds, a more resilient portfolio is possible, one that is capable of better navigating uncertainty, paving the way for a more positive investment outcome in an ever-changing investment landscape.


Learn more about combining low-correlating strategies >

The Fund’s investment objectives, risks, charges, and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company, and it may be obtained by calling 1.855.LCFUNDS, or visiting www.LoCorrFunds.com. Read it carefully before investing.