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.

Further, by decoupling portfolios from bond markets, a market-neutral strategy may help shield portfolios from rising interest rates. While the return stream of a market-neutral investment is not expected to exceed that of the equity market during bullish periods, market-neutral strategies tend to thrive when other major asset classes are underperforming or falling.

The addition of a market-neutral allocation within the core portfolio ensures that the strategy will have the opportunity to benefit the client’s portfolio across all market cycles. A market-neutral strategy that has historically delivered mid-to-high single-digit returns with many of the diversification benefits of a hedged strategy is likely to suit investors well over the long term.

While market-neutral funds have historically lagged behind stocks, the importance of independence from market forces becomes evident during bear markets, such as during 2000 to 2002 or 2008 or even during political and economic events such as Brexit that elicit meaningful market reactions from investors. 

Allocating to market neutral strategically, rather than tactically, ensures that the strategy will be able to impact the portfolio across all market cycles.

The question of how much advisors should allocate to market-neutral investments is a more challenging one. While individual risk preferences will always dictate allocation amounts, advisors must make a large enough allocation to have a statistically meaningful impact on the portfolio. The 2016 NACUBO-Commonfund Study found that U.S. university endowments and foundations allocate between 10%–60% of total assets to alternatives.