The Best Ways to Diversify Your Investment Portfolio in Today’s Market

Key Takeaways Include:

• The effectiveness of a 60/40 portfolio versus broader diversification approaches in today’s environment.
• How diversifiers like gold, Treasuries, and alternatives have performed under recent and long-term market stress.
• Practical tips for incorporating nontraditional asset classes to enhance long-term risk-adjusted returns.

Christine Benz: Hi, I’m Christine Benz from Morningstar. Welcome to today’s special webinar about diversification and correlations among various asset classes, where we’ll be delving into findings from a recently released white paper called 2025 Diversification Landscape. To download the paper, view the Attachments tab on BrightTalk or the Comments section on LinkedIn.

Before we begin today’s conversation, we want to take a minute to make sure that you get the most from our presentation today. Today’s webinar will be recorded and available on demand after the live session. All registrants will be emailed a link to the playback following the presentation.

I’m joined today by my two co-authors on the research. Amy Arnott is a portfolio strategist with Morningstar, and she’s been leading this research since the beginning. Karen Zaya is associate director in Morningstar Manager Research Group. She’s also here today. We’ve prepared a long list of topics to talk through, but we will also be taking time to answer your questions. Attendees on BrightTalk can submit a question through the Ask a Question button at the bottom of their screens. Viewers on LinkedIn can leave a comment.

Research Overview

So Amy, I want to start with you, and I’m hoping you can kick us off by talking about the goals for this research, who the intended audience is, and how we would hope that they would use this research to inform their decision-making.

Amy Arnott: Yeah, so the goal is really to take a broad view of investment performance across asset classes. And we wanted to look at the correlation patterns between those asset classes, how they might have changed over time, and what that means for building a diversified portfolio. The audience would be anyone who is trying to build a portfolio, so it could be individual investors, as well as financial advisors building portfolios for their clients. And as far as how to use the research, there are a few different ways.

One would be as a cross check on whether asset classes diversify as well as you think they will. You can also use it to kind of take a deep dive into an individual asset class and how it might fit together with other asset classes. And then just more generally, we’re hoping to get people thinking about asset classes they might want to include or not include in a portfolio.

Measuring Correlations & Tariff Policy Implications

Benz: OK. Karen, I want to turn to you and talk about how we measure correlations. People will be looking at one of these correlations grids on the screen. Maybe you can talk about what we use as the baseline asset for measuring correlations and subsequently run correlations against.

Karen Zaya: So, the baseline holding is the Morningstar US Market Index. And since we’re taking the perspective of a US-based investor, who typically builds a portfolio with a foundation in US stocks, and so when we talk about correlations of bonds to this baseline, we mean how directionally similar those asset class returns are to that of the US equity market.

And just maybe if we look at the matrix on the screen now, I can walk through a quick example. A matrix like this depicts a three-year correlation between pairs of asset classes. And so if you see that peach-colored negative 0.05 in the second column, it’s in the second column, which corresponds to the second row, so the commodity index, and it’s in the eighth row, so that is the Morningstar US 10+ Year Treasury Index. And so we’re seeing that those two asset classes are not correlated, since you have that near-zero value.

Benz: That’s helpful. So people who read the research might ask where they can get these kind of correlation matrices, or perhaps build their own with their own set of assets. Can you talk us through that, Karen?

Zaya: So, Morningstar Direct has interactive charts where you can add benchmarks, funds, and so on to generate a matrix like you get in the paper, but also to make the rolling correlation charts where you see it over time. And you can also pull those numbers directly in the workspace area. There’s a correlation data point there.

Benz: OK, great. Amy, I want to ask you about the predictiveness of these correlations. So these are backward-looking. What we just looked at was the three-year correlation. But how should people think about that, whether they can take to the bank the correlations that have held true historically?

Arnott: I would say that correlation patterns are directionally predictive. We don’t typically see a given asset class bouncing around from a negative to a positive correlation versus stocks from year to year. There can be some changes over time, but typically we see asset classes kind of landing in a similar range.

Benz: OK. So I guess the question is today, does that seem like a particularly big risk? That we have this tariff policy, which doesn’t have a precedent in modern economic history? Is there a risk that the trends we discern in correlations today really might not hold up going forward?

Arnott: I think that is definitely an issue that everyone is trying to grapple with. But the level of uncertainty about tariff policy is so high right now, although, you know, we did have some news coming out this morning about a tariff agreement with the UK, which the market seems to be reacting positively to.

But as far as the rest of the world, we don’t really know what shape these tariffs will ultimately take and what the impact will be on the economy. And, as you said, we don’t really have a lot of reference points in modern history for the potential impact of tariffs.

You could go back to Smoot-Hawley back in March of 1930, which didn’t cause the Great Depression but definitely was a contributor to it. So I think if you’re thinking about the impact of tariffs generally, it’s probably not going to be positive for economic growth.

So you could look to the recessionary periods that we examine in the paper for some of the potential impacts on correlations there. We still have inflation running above target, with a 2.4% inflation rate for the most recent announcement. And again, tariffs, we don’t know what the exact impact will be on inflation, but it’s probably not going to be positive.

So, those are some of the issues that we’re grappling with right now. And there definitely could be some changes to the previous patterns we’ve seen with correlations between asset classes.

Benz: OK, that’s helpful. And I do have a question about stagflation for you later on, Amy. But first, we want to take a moment to ask the audience a poll question. So, in the face of tariffs, what assets are you adding to help diversify portfolios, and the choices are gold, international equities, Treasury Inflation-Protected Securities, or cash. So if you can, go ahead and make your selection there and we will move on.

Karen, I want to ask you about the extent to which correlations measure two assets, how the two assets have been directionally similar, but it doesn’t pick up on divergent performance patterns. Can you walk us through that?

Zaya: Sure. So correlation, like you said, measures only the direction and not the magnitude of the similarity of return. So if you have two assets that have a high correlation coefficient, but then their performance can look different because of the magnitude issue. So even if they both tend to go up at the same time, if one asset goes up threefold what the other does, that’s going to result in a really different performance experience.

Benz: OK. So a great recent example would be international equities leading up to this year, correlations rose, but non-US stocks severely underperformed US.

Karen, I wanted to get into the key findings. One thing that we have observed in previous versions of this research is that correlations among major asset classes have been rising. As you look at the 2025 research, which measured correlations through the end of 2024, is that pattern persistent?

Zaya: So somewhat, like for some asset classes, you did see correlations rise. For some of them, it came down. Generally, though, compared to, I’d say, the previous couple of years, correlation slightly came down in 2024, but they’re still really elevated compared to the longer, 2025 year history.

Benz: OK. So, looking at that graph, it looks like 2021-ish was kind of an inflection point where we saw the correlations between major asset classes relative to US equities really jump. Can you talk about that period?

Zaya: Yeah. So that tends to happen when there’s maybe an eventful few years, which the last few have been. We’ve been through a fundamental regime change, and macro environments really impact correlations, in particular during a stress period or an acute crisis. Like this happened in 2008, with the global financial crisis, you can see that big jump. And then, in 2021, it was a matter of inflation and rising interest rates. And when those took hold, correlations jumped.

Evaluation of the 60/40 Portfolio

Benz: OK. Amy, going back to you, one question that you examined in the paper is the extent to which holding other assets, like non-US stocks, would have helped or hindered relative to a US stock-only portfolio, or a 60/40 portfolio consisting of only US stocks and bonds, you found that that US 60/40 was quite hard to beat in the 20-year period through the end of 2024. Can you talk about the major drivers, about why that very basic portfolio was pretty unassailable?

Arnott: Yeah, so I would point to three major drivers that were in place over that two-decade period. One is that over the 20-year period through the end of 2024, it was a mostly uninterrupted bull market, except for a small loss on stocks in 2018 and obviously the bear market in stocks and bonds in 2022.

You also had generally declining interest rates with the Federal Research following a zero interest-rate policy, where they were keeping the target interest rates very low starting in 2008. And that policy continued up until the beginning of 2022.

And then, third, over that two-decade period, the dollar was generally trending higher. So that was one of the main headwinds for international stocks, for US-based investors. So we don’t know what’s going to happen in the future, but I would say, you know, the likelihood that all three of those factors would continue over the next 20 years is probably pretty low.

Benz: OK. So 2025, it appears to be a little bit different. Diversification seems to be having a bit of a moment so far in 2025, with non-US, in particular, doing better. But, Amy, can you talk about that, some of the key drivers of the relatively better case for a more diffuse portfolio today?

Arnott: Yeah, so we put together this, what we call a diversified portfolio, which includes a broad range of asset classes, 11 different asset classes. And through the end of the day yesterday, that diversified portfolio was up about 3.6% for the year to date versus negative 1.4% for the basic, plain-vanilla 60/40 portfolio. So you have a gap of almost 5 percentage points, which is pretty significant.

So some of the main reasons I would point to for the diversified portfolio doing so much better this year, one, as you mentioned, is international stocks. So if you look at non-US stocks from developed markets, they’ve gained about 12.6% for the year to date, partly because valuations were more attractive going into the year. You also have a different sector profile for international stocks, as well as some weakness in the dollar.

Gold has been another major positive. So gold has been hitting all-time highs. It’s up about 30% so far this year. And that has really been driven by a lot of central bank buying around the world. Central banks try to diversify their dollar exposure, as well as other investors purchasing gold as a safe haven amid a lot of uncertainty and volatility around the world.

And then a couple of other asset classes that have also benefited the diversified portfolio. One would be commodities, where there has been some mixed performance, with oil not doing well, but other assets like natural gas and copper doing very well so far this year. And bonds have also been a net positive, with investment-grade bonds up about 2.7% so far this year.

Benz: OK, that’s helpful, Amy. We’d like to ask another poll question. We’ll take a moment for that. The question is, which diversifying assets are your clients most skeptical of? So I know that we usually have a healthy contingent of financial advisors in the audience for these events. So the choices are bonds, international equities, or alternative investments, which we’ll be delving into later on in the course of this discussion.

We also want to take a moment to remind you to submit your questions. Attendees on BrightTalk can submit a question through the Ask a Question button at the bottom of their screens. Viewers on LinkedIn can submit questions via the comments field.

So, Amy, we’re going to turn the tables a little bit to talk about fixed income, where I focused for this research. And maybe you can lob a few questions at me about what we can discern when we look at fixed-income correlations relative to equities.

Bonds & Fixed Income

Arnott: Sure. So, you know, we have these sections of the paper focusing on taxable bonds, as well as municipal bonds. If you’re looking kind of broadly at fixed income correlations versus stocks, what are some of the main trends you would note there?

Benz: Sure. So, historically, high-quality fixed income had been a great diversifier for equities, especially in recessionary shock. Where bonds picked up, where stocks left off. But Karen referenced that inflection point in 2021 when we saw interest rates shoot up. And basically the same thing that was bugging stocks during that time was also bugging bonds—that investors, bond investors—were worried about rising rates, so we saw a decline in bond prices at the same time stock prices were falling. Which is why when you look at the correlation trends on this graph, you do see that spike up in terms of correlations.

We throw cash into the mix when looking at fixed-income correlations. Of course, cash is not bonds, but it’s the closest sort of category for them. And one thing we see is that cash actually looked really good as a diversifier during that particular period. That the reason was that cash holders were the beneficiary of higher rates, right? They had higher yields, which helped augment their returns, whereas bondholders had losses due to rising rates, which is why cash looks so good from the standpoint of diversification and correlations during this recent downturn.

Arnott: So does that mean that investors should kind of downplay bonds in their portfolios and prioritize cash instead? And how should people think about how much to allocate to cash versus bonds?

Benz: It’s a big question, and I think that it is very hard to encourage investors to love bonds. Because their recent experience has not been great. But over time, I think we would expect bond returns to be ahead of cash. And the other key point is that bond yields are a lot higher today, which means that the raw materials for their returns over the next decade are much better than they were when yields were ultralow. So they have more of a cushion against future losses and potential interest-rate changes. So that is an important point in fixed income’s favor.

And the other key point on cash is just that inflation, and you mentioned inflation earlier, Amy, is just going to eat away at the purchasing power. It’ll eat away at the purchasing power on fixed-income investments as well, but especially cash, because the yields are generally lower than they are for fixed-income instruments.

So, in terms of allocations, the old rule of thumb to hold roughly three to six months worth of living expenses in cash makes sense for working people. For older adults who are drawing upon their portfolios, I like the idea of holding more like one to two years worth of liquid reserves. And the idea is, if you’re sourcing cash flows from your portfolio during retirement, you do want protection against having to draw from depreciated assets during a period like 2022. So I think one to two years is kind of a good starting point for retiree spending.

Arnott: The one issue that has come up this year is that Treasury bonds haven’t been quite as stable as usual during some of the periods of maximum equity volatility. So far this year, we’ve had a couple of days when there were major downtrends in stocks as well as Treasury yields at the same time. And there’s been some chatter about are Treasuries no longer a safe asset that people flee to in times of market volatility? Is that concern legitimate, in your view?

Benz: Well, there have been a few days of bobbles, especially as you mentioned, Amy, in those periods of maximum equity market duress. I will say that it’s not without precedent. So we did have similar sort of dislocation in Treasury prices in the very early days of the pandemic. But there is some consternation that have investors lost faith in dollar-denominated assets writ large. I think that’s still an open question. My guess is that the bigger force there is that, as we’ve talked about, that the tariffs have the potential to be somewhat inflationary. And so I think the concern among bondholders in the early days of the tariff talk was that we might see rising interest rates come online at some point to combat inflation. So my guess is that that was probably what was going on there.

And then I would also note, Amy, that over the broader sweep of this recent equity market volatility, Treasury have actually been great. They have been some of the best performer. Performing sort of vanilla asset ingredients that investors might have in their portfolios. So if you dial back a little bit, Treasuries have actually been really great equity ballast.

Arnott: OK. So, looking at the entire fixed-income landscape, are there any asset classes that you think are somewhat overrated from the standpoint of diversifying your equity exposure?

Benz: Low-quality fixed income is not your best friend if your aim is to diversify equity exposure. What we’ve seen in this year’s research, and in previous iterations of it, is that low-quality bonds, or junk bonds, tend to move in sympathy with the equity market. So, you might have other reasons to have a small allocation to junk bonds, but diversifying is not one of them or is not a good reason.

Another category I would call out, Amy, would be the core-plus, intermediate-term bond core-plus. These are fixed-income categories, or a fixed-income category that has an allocation to lower-quality fixed income. What we see is that they tend to be a little less reliable as equity diversifiers versus, say, an intermediate term core fund. Like a total bond market index, for example. So those are a couple that I would call out.

Arnott: So, as I mentioned earlier, the paper also has a section on municipal bonds. How have munis historically diversified equities, and have they been as strong a diversifier as taxable bonds and especially Treasuries?

Benz: Yeah, they haven’t, actually. They have been kind of a bit better than high-quality corporate bonds, but municipal bonds haven’t been as reliable for diversification as have Treasury bonds. I would say, though, they have been fairly reliable equity ballast. So I think that investors for their taxable portfolios, if they’re in high tax brackets, and they’re looking to diversify equities, I think munis are a decent place to look. Just be careful not to gravitate to the lower-quality munis. Because, like lower-quality corporates, we’ll tend to see performance more in line with the equity market.

Arnott: That’s helpful. And how have municipal bonds been performing so far this year?

Benz: Not great. This has been a little bit of a surprise. And it sounds like there are a couple of things going on there. One is that valuations were a little bit stretched in the muni market coming into 2025. And then I’ve also been reading that the issuance has been greater in the municipal space as well. So munis haven’t performed as well as Treasury certainly during this period. But as kind of an antidote to equities, I think they’ve done OK. I think that the recent performance is a little disappointing, but they’ve been reasonably steady during this period.

Commodities & Alternatives

So, Karen, I want to turn it over to you. You led the section on commodities and liquid alternatives for this paper. Let’s start with commodities and talk about how they’ve done to diversify stocks.

Zaya: So, I’ll point out that while many other asset classes’ correlations have trended up since 2021, it’s been the opposite for commodities. Those correlation lines, as you can see in this chart, have been coming down. And in both 2022 and 2023, commodities did the opposite of what bonds and stocks did, for better and worse.

So in 2022, the Bloomberg Commodities Index was up, while stocks and bonds were down in the double digits. And then, in 2023, the commodities index was down while stocks and bonds were up. And in 2024, the commodities basket gained a solid 5%, which was short of stocks’ 24%, but considerably more than what bonds returned, which was about 1.5%.

Benz: OK. So gold, in particular, has been soaring, as we’ve referenced. Can you talk about what’s driving that enthusiasm?

Zaya: Yeah. So themes from the last few years have carried over and generally been amplified. So, in 2024, the backdrop of the US presidential election and the likelihood of Trump winning the election, in light of all of that, many anticipated that the Trump administration’s policy would increase debt, which would further weaken the dollar and raise inflation, making gold an even more attractive safe-haven asset class. Additionally, the administration’s plans for tariffs further strained geopolitical tensions. And so these anticipated factors have occurred. And so we’ve seen it play out in gold prices.

Benz: OK. How have commodities done, broadly speaking, so far in 2025?

Zaya: So it’s been a mixed bag. The Bloomberg Commodities Index, so that kind of general basket, returned about 3.6% in the first third of 2025. Gold’s been a really big winner with about 26.5%. Copper as well, with 14%. While oil has suffered, the Bloomberg Sub WTI Crude Index lost about 16% in these first four months of the year.

Benz: OK, so it sounds like commodities have done a decent job diversifying equities, or perhaps diversifying a 60/40 portfolio over time. Do you have a favorite approach for investors obtaining exposure to commodities? Should they look to one of those broad market funds or ETFs, or should they just go straight for gold? How should investors approach it?

Zaya: So I’d say those two options kind of come to mind as the first ones I’d consider. If you want to diversify against the risk of a market drawdown, gold could likely fill that role best. But if you’re worried about inflation, a broad basket of commodities could probably be a better bet because gold has had a more sporadic record as an inflation hedge.

Benz: OK. So, Karen, I mentioned that we want to talk a little bit about stagflation, which has been the breakout hot economic risk of 2025. We don’t have any super recent reference points for stagflation. I suppose the most recent was the 1970s. Can you talk about that period? What assets actually did OK during that period?

Zaya: Yeah, gold did well. So gold, and, you know, gold’s doing well now.

Benz: Right.

Zaya: As did silver and maybe some other precious metals. Oil, too, had done well during that period. A lot of that was driven by the oil embargo and the related price shocks. And then, as is typical when you’re dealing with commodities, the supply and demand around some agricultural commodities, you know, provided some lift for a few of those.

Benz: OK. So, moving away from commodities and gold, we want to talk about alternatives. And you also led up this section of the paper. Before we get into alternative investments, can you talk about what types of investments we’re talking about here? What falls under that umbrella?

Zaya: Definitely. So it is definitely an umbrella term. And so first, we’ll just in this section, we’ll be talking specifically about liquid alternatives. And these are strategies, that modify, diversify, or eliminate traditional market risks. And so what they do instead is they incorporate nontraditional or alternative risk factors, or betas like carry and momentum and trend.

In this world, you generally see a lot of trading securities long and short, more unique and complex approaches with more-esoteric holdings. So think about like an equity market-neutral fund, event-driven, which you’ve made heard about, like merger-arbitrage, systematic trend. And then you also have those modifier liquid alts, or like long-short equity and equity-hedged, which used to be called options trading until this past October in our category system. Those behave a little bit more like equities but are still different enough to call out.

Benz: OK. So, do any of these alternatives make a case for themselves, make a good case for themselves, I should say, alongside a diversified stock/bond portfolio? And, if so, which ones look good?

Zaya: Yeah, I would call out equity market-neutral and systematic trend strategies. So you can see from this chart, their correlations tend to sit solidly below many of the other categories. And equity market neutrals name says it all, it’s supposed to be, you know, just not acting like the equity market. And that correlation tends to be around zero, on average. And with systematic trend, it tends to have, I think, in the last three years, it was like a negative 0.37 correlation that we ended up with. And that’s like a weekly or moderately negatively correlated asset class.

Other Equities: Styles, Factors, Sectors, International

Benz: OK. So, I know our research focused on the period through 2024, but 2025 has been so unusual that I wanted to ask about alternative assets during this period. How have they shown themselves so far this year?

Zaya: Yeah, So this year, over the first four months of 2025, equity market-neutral has really been the category that’s delivered, of the liquid alternative categories that we looked at in this research, that category had the best average returns in those first few months. And it was an actual positive return.

Relative value arbitrage also came in a close second. While systematic trend, which is typically a good diversifier, had a tough first few months, but that’s kind of expected. Those strategies can go through some bouts of underperformance when there’s extreme market volatility.

Benz: Thanks. Amy, I want to turn back to you and dig into equities a little bit. You looked at the style boxes with respect to diversification. Can you talk about that? Which investment styles have done a good job of diversifying the broad US market?

Arnott: Yeah. So if you look at the Morningstar Style Box, a lot of people are probably familiar with the nine box grid going from value to growth and large to small, it’s really the value side that kind of stands out from a diversification standpoint. So if you look at the small-cap value square, for example, the correlation coefficient over the past three years has been 0.83 versus the overall equity market, which is relatively low. And even large value is also relatively low at 0.85.

Benz: OK. And you note that examining investment styles is a particularly good example of how correlations don’t necessarily equate to investment returns. Can you talk us through that?

Arnott: Yeah. So, across all of the nine boxes of the style box, all of the correlations are positive, but we do sometimes see pretty dramatic divergences in returns. So going back to 2024, for example, you had large-growth stocks gaining about 28%, but small value was only up about 9.7%. And then kind of on the flip side, going back to the 2022 bear market, large-growth stocks actually lost about 40%, but large-value stocks finished the year just a little bit in the black, with a gain of about 0.3%. So, I think that, as you said, it really kind of underscores the fact that correlations show you how closely things move together, directionally, but not necessarily the magnitude of those movements.

Benz: Right. You also examined factors within the equity space. Can you talk through what we mean by factors in this context?

Arnott: Factors are another way of explaining market performance and looking at the underlying drivers that different stocks have in common. Some of the most common factors would be things like quality, size, momentum, yield, low volatility, etc.

Benz: OK. So different factors have had varying degrees of success in terms of diversifying US equity exposure. Can you talk about that, which looked the most promising if someone wanted to lean into a specific factor or two?

Arnott: I would point to the low-volatility factor as something that really stands out from a diversification standpoint. Although, across all of the major factors, they do tend to have pretty high correlations with the market. So I’m not sure if there’s really a strong case to be made for necessarily diversifying by factor.

Benz: OK, good to know. So now we want to talk about sectors, Amy, And perhaps you can lob a couple of questions at me because that was a section of the paper that I took the lead on.

Arnott: Sure. So if you’re looking across economic sectors, are there any sectors that you would point to as being particularly good at diversifying broad US equity exposure, or, on the flip side, any that seem particularly disappointing from a diversification standpoint?

Benz: Sure. In the positive vein, energy has looked like a stellar diversifier for the broad US equity market over the past several years. To a lesser extent, utilities have also helped diversify broad US equity exposure. And then, in terms of what has looked less than stellar, technology stocks. And I think that’s simply because the US market today is so dominated by those Big Tech behemoths that adding an additional technology sector fund, or ETF, for example, just kind of gives you more of the same. So, investors might have some investment case to layer on additional technology exposure, but there’s definitely not a diversification or correlations case.

Arnott: As you look at US equity performance so far in 2025, including style boxes, factors, and sectors, are there any categories that have really stood out as being safe havens?

Benz: You’ve referenced a couple of them, Amy. So the value column of the style box, especially large value, has looked relatively good alongside the broad US market. Low volatility as well, having a really great period so far this year. So those are a couple of the areas that have made a good case for themselves in this broad market downdraft that we’ve been experiencing.

Arnott: One ongoing theme that we have seen in this research is just how disappointing non-US stocks have been from a diversification standpoint. Not only have we seen correlations trend up for non-US stocks, but there’s also been this pretty huge performance gap, at least through the end of 2024. Can you talk about those patterns and some of the reasons behind them?

Benz: Right. We have seen increasing correlations between US and non-US, and in terms of the reasons, it’s, I think, just that our global economies, at least until recently, have become more and more linked. And so what I would call out is that the emerging markets appears to be a better diversifier for US equities. So that’s represented on the red line on this chart, which I don’t think means that investors necessarily need to run out and buy an emerging-markets-specific fund, but to the extent that they have broad non-US exposure in their portfolios, I think this suggests that if the goal is to diversify US equities, they would probably want to include some emerging markets in whatever they’re holding for that exposure.

Arnott: And what about in 2025? As I mentioned earlier, we have seen better performance from international stocks. Why is that, and is there any reason to believe that that trend can continue?

Benz: I think valuation was probably the key catalyst. Valuation, combined with the tariff news, has stoked a really resurgent performance pattern from non-US stocks so far this year. And it does appear that that valuation advantage is still there for non-US. So I think that investors have good reason to consider topping up their non-US exposures. It’s been very easy to let the path of least resistance back in, where you haven’t necessarily been adding to non-US exposure, but I think this recent performance is a bit of a wake-up call to revisit those allocations.

Private Equity and Credit

Karen, I want to go back to you and talk about private securities, which is a real buzzy area lately. You delved into the potential investments—the potential benefits—of adding private investments to a portfolio. First, can you talk about what are the most common types of private investments?

Zaya: Sure. So most commonly, people might think about private equity, venture capital, private debt. There’s also private real estate, private real assets or infrastructure, and then also fund to funds and secondaries. Those are the main things that surface.

Benz: OK. So can you talk about what you found about their value, or perhaps lack thereof, in diversifying a portfolio? And maybe you can talk about the challenges for individual investors who might be delving into private investments, versus institutional investors who might be mining the same general terrain.

Zaya: Yeah, gladly. So the diversification benefit from our analysis has been pretty inconsistent, which I don’t think should come as much of a surprise. Private equities are equities. And so a lot of what is going to impact the public markets is going to impact private companies as well. In this chart, you see a lot of really dramatic and frequent jumps in correlations, but for the most part, you see the correlations are pretty high, right? They’re like, really living at the top of that chart. I think sometimes people may conflate breadth with diversification, because having access to more companies doesn’t really mean that broader set of companies behaves differently.

And then regarding challenges for individual investors, the inherent lack of liquidity makes private investments hard for individual investors that are planning to fund a goal at a specific time, whereas a university endowment, an institutional investor like that, has an infinite time horizon. And then fees are also higher, and there’s less transparency than what individual investors are used to. And so even with semiliquid vehicles like interval funds, which are very much top of mind, I think, for a lot of people right now, those are SEC-regulated ’40 Act closed-end funds that can hold more in private investments. So that’s like an access point that might seem a little more familiar, but it would be a totally, very different experience for individual investors. Like, they’re still more expensive, less transparent, and less liquid. And so, hopefully, the interval fund ratings we’re planning on launching later this year will help individual investors make well-informed decisions about whether these options are right for them or not.

Benz: OK. Karen, can you talk about 2025 and perhaps discuss the performance lag that is there for reporting the returns of private securities? Can you talk about how that’s kind of an impediment to getting our arms around how they’ve really performed during a period like this, that we might not know until a bit later?

Zaya: Yeah, we definitely won’t see what’s kind of happened quite yet. It’ll take us a little time because private funds report their results on a lag. They just don’t have the same obligations as more heavily regulated funds. And there’s also, I think, this element of kind of guarding their edge and keeping things close to the vest, which then leads into that transparency issue I had mentioned before. Also, the reporting scheme does tend to be more complex, and they rely on these like really discretionary valuation techniques. And that kind of accounting also takes time to accomplish at the end of each quarter.

Benz: OK, so how about in previous equity market shocks? Can you talk about how private securities have done during periods like that?

Zaya: Yeah. So, like after the covid drawdown in early 2020, we do know that venture capital, private equity, and some secondaries also suffered some losses. And then, over 2022 and 2023, weaker growth and higher interest rates ate into private equity returns. And that’s because the cost of capital and leverage increased and the market uncertainty just slowed down dealmaking. And so you do see the same or similar things play out in the private-market space. And though it seems more muted, some of that is just because of the delay. Some of it is because of discretionary valuations and also the less frequent pricing cadence.

Concluding Key Takeaways

Benz: OK, that’s helpful. Amy, I want to take it back to you. You’ve led this research since the beginning. We’ve seen a lot of interesting things in the market over that five-year period. Maybe you can talk about the two or three key takeaways. As you think about this research and the whole body of research that you’ve led on correlation and diversification, what are the two or three takeaways that you hope investors will have?

Arnott: Yeah, so one thing I would say is diversification is a good thing. You know, it might seem like an obvious point, but I think it’s worth repeating. And I think often gets lost, especially if you’re in a really strong bull market. I think people sometimes have a tendency to just look at the best performing asset classes and want to maximize their exposure there. But the reason you want to diversify is to reduce the risk of your portfolio. And then also hedge against the uncertainty that is kind of inherent in investing. Because you never know which asset classes are going to end up at the top or bottom of the performance charts in any given year. So that’s why you want to be diversified.

A second key point I would point out is that regimes are important. We talked earlier about the long period of low inflation and declining rates that we had up until a couple of years ago, and how things have significantly changed since then. And in turn, we’ve seen correlation patterns change, especially with bond, stock and bond correlations flipping from negative to positive.

And then third, I would say, is building a diversified portfolio doesn’t have to be complicated. And more diversification isn’t necessarily better. So I think if you even had a pretty simple approach of just buying U.S. stocks, international stocks, and investment-grade bonds, I think just having exposure to those three asset classes can get you pretty far from a diversification standpoint. And then if you wanted to add more-specialized asset classes, like commodities or real estate or gold, I think those are optional, but you don’t have to feel obligated to include every single asset class in your portfolio.

Benz: OK, great. Karen, I wanted to ask you, you’ve been a repeat contributor to this research. When you think about working on it again next year, what are some of the topics that you’d like to explore in next year’s research?

Zaya: Yeah, so many things. But I think, top of mind, I would just go back to what we were talking about a second ago. I’d be interested to see how the recent macro events kind of play out in the private-market space. And in particular, if you look at an interval fund portfolio that mixes both public and private assets, let’s see how those reacted in that time space.

Audience Q&A

Benz: OK. So we’re going to start tackling some of your questions. If you’d like to submit them, please do so now. But we have a couple of questions, or more than a couple, that have come in, and so we’ll get through as many of these as time allows.

The first question I think I’ll hop on, which is thoughts about diversifying into ex-US assets at this time. And probably the “at this time” is a pivotal aspect of this question. If you are deciding to add to non-US, you haven’t timed it perfectly if you’re just looking at them now, but I think that there’s probably still gas in the tank. And my bias would be for investors to maintain globally diversified portfolios, especially for young investors with long time horizons, where the currency risk is less of a factor for them. I would be supportive of almost mirroring the global market caps ratio of non-US relative to US, which is, I think, about 35/65 today. And then perhaps as people move into the spend-down phase, if they’re retired and spending from their portfolio, maybe they’d want to back off of that non-US allocation a little bit as they get closer to needing their money. But that’s how I would approach it anyway.

Karen, question here for you. I think it’s kind of a terminology question, more than anything. It’s about managed futures. You had talked about some of the alternative categories. Maybe you can talk about how managed futures fit in. I think we call them something else, right?

Zaya: We do. Thank you. That’s a very good point to make. So we call managed futures funds, those fall in the systematic trend category. So those are the ones that recently had been suffering because of the market volatility. And they do tend to go through bouts of outperformance and underperformance, but they’re one of those, it was one of those lower lines that were negatively correlated to the equity market. So when I say systematic trend, I’m thinking about managed futures at the same time.

Benz: OK, great. Thanks, Karen. Amy, a question came in about dividend strategies and how we might expect them to behave in a higher tariff regime. Can you talk about that?

Arnott: Yeah. So if you are looking at the potential impact of tariffs and thinking that it might lead to lower economic growth or even a recession, I think in that type of environment, we typically see higher-quality dividend stocks performing relatively well. So I think you could definitely make a case for having some exposure to dividend-paying stocks. Although, I think if you are looking at the highest-yielding stocks, then you might be courting some other risks. Those types of stocks tend to be more cyclical and might be more vulnerable in an economic decline.

Benz: OK. Not surprisingly, we’re getting lots of questions about the current environment. And here’s a good question for you, Amy. It’s about which specific types of asset classes or strategies stand out as better diversifiers in the current macroeconomic environment? So where we have the potential of slowing growth, the potential of higher prices, are there any areas that you think make more sense if someone wants to diversify, kind of a US 60/40?

Arnott: Yeah, I think, you know, as you mentioned, I think that there is a pretty strong case for diversifying into international stocks. And, you know, it’s hard to think of a lot of other areas that would be completely immune to the potential impact of tariffs. I guess you could say gold, potentially cash. Feel free to chime in if I’m leaving anything out.

Benz: Yeah, no, that’s helpful, Amy. Here’s a question that I will take about how REITS have performed. And so the question is about publicly traded REITS in particular. We do look at a real estate index in this research, and what we have found, and I didn’t highlight it in my discussion of sectors, but I probably should have, is that its value as a diversifier has slowly ebbed away. That I remember, 20 years ago, when I was an analyst, it was sort of like, oh, you definitely need a REITS fund in your portfolio. Well, there doesn’t appear to be a strong correlation case for adding REITS where we’ve seen the correlation jump up relative to US equities fairly significantly. Now, there might be valuation reasons or income reasons that someone might gravitate to real estate securities in their portfolio, but from a portfolio construction standpoint, I don’t see a strong case for REITS.

Here’s a question about retirement income versus the accumulation phase. So the question is, how are your research and conclusions affected if an investor is using the portfolio for retirement income versus the accumulation phase? Amy, do you want to tackle that?

Arnott: Sure. I would say that when you’re starting to draw down assets from your portfolio in retirement, I think time horizon becomes more important. So I would say diversification is still something that you want to pursue for your portfolio, but I think you want to be thinking about sequence of returns risk and what are your cash flow needs going to be over the next two years, the next several years beyond that, and then longer term. So I think when you’re entering retirement, I think those types of time horizon and bucketing decisions can be as important as diversification.

Benz: Here’s a question about whether old school portfolio strategies like 80/20 equities relative to fixed income, 70/30, 60/40, and/or target-date funds, do those vanilla-ish asset allocations still make sense, or should we look for new strategies in this changing world? I think what I’m picking up on from these questions is just a lot of uncertainty about how rapidly things are changing in the macro environment.

Arnott: Maybe I’ll start on, I think, if you’re an asset-management firm, I think a lot of them have been pushing the narrative that you need to go beyond 60/40 and be adding pretty heavy exposure to alternative asset classes, or private equity and private credit. I think I personally tend more toward the keeping things simple side, and I’m a bit skeptical about whether people need to add a lot of nontraditional asset classes, especially given the fact that those types of asset classes often come with significantly higher costs.

Benz: I saw a question about inflationary and recessionary environments, and there is a section in the paper that delves into how various assets have performed. I’ll take the recessionary period question because that was a focus of my section. And long story short is that bonds have historically been quite good. High-quality fixed income, especially Treasuries, during recessionary periods that are often kind of a flight to quality where equities sell off, but high-quality fixed-income assets consistently over recessionary periods have delivered. In some periods, maybe somewhat counterintuitively, some recessionary periods, stocks have actually held up reasonably well, but bonds have been very good diversifiers very consistently during recessionary periods. So inflationary environments, do either of you want to hop on that one?

Arnott: So, I would say, in an inflationary environment, it’s not necessarily negative for stocks, and you can see stocks perform well during more inflationary environments. Definitely tends to be more of a negative on the bond side. And we also have seen a pattern during periods of higher inflation where correlations between stocks and bonds tend to be much higher than in periods of lower inflation, which reduces the benefit of diversifying into bonds.

Benz: Last question. And Amy, I’m hoping you can take this one. What should advisors highlight to their clients from this report?

Arnott: So it’s a long report. It’s 60 pages, I think, so there’s a lot of stuff there. But I think the one thing I would point to is the first exhibit in the appendix, which is Exhibit A1, which is that market quilt of showing performance for different asset classes from year to year. I think that is really a great way to illustrate the fact that performance patterns are unpredictable and do tend to change around. I think that is a really great way for advisors to illustrate to their clients why diversification is so important.

Benz: OK, well, that will have to be our last question for today. As a reminder, we’ve included a link to this Diversification Landscape white paper in the Attachments tab, and we’ve also included a link to register for the Morningstar Investment Conference, which we’ll be holding June 25 and 26 here in beautiful downtown Chicago.

Finally, I’d like to note that Karen is going to be conducting an upcoming webinar about some research of hers. That will delve into our ratings system for semiliquid funds. That session is called Morningstar Medalist Rating for Semiliquid Funds: A New Framework for a Converging Market. I attached the presentation deck for you to check them out.

Thank you so much for taking time out of your schedule to join us today, and we’ll see you soon on Morningstar.com where Karen, Amy, and I, and the rest of the Morningstar team are regularly posting content. Have a great day.