A simple taxonomy of diversification - All diversifiers are not alike

When I hear about diversification across funds or strategies, I, like most investors, will immediately focus on the correlation matrix rather than on other alternatives and asset classes. However, investors should think beyond simple historical numbers and focus on forward-looking expectations for correlations. There should be views of how diversification may change through time or behave under different scenarios. To form diversification or correlation forecasts, investors should have a classification scheme for diversification. Not all diversification is alike, and a classification scheme may help determine how correlations may shift. 

For example, if an investor asks for a strategy with diversification to protect in a crisis, they have embedded a forward view of what they would like the correlation to look like under an extreme scenario. There is also weight placed on the likelihood of a crisis that may disrupt correlations.

More generally, the correlation of an asset class or a fund is based on the sensitivities to different factors or risk premiums. A simple taxonomy of diversification could break down a market, manager, or strategy into five different types or buckets. The easiest diversification classification is an asset class. However, asset-class correlations can change with the business cycle, investment flows, and during crises. The simplest and perhaps best diversification currently is the negative relationship between stocks and bonds; however, there have been long periods when this correlation has actually been positive. Any diversification strategy has to account for the fact that the negative stock-bond correlation is not definitive.

A second type of diversification is based on factors. Factor-based diversification is often confused with alternative risk premiums. Our view is that a factor could be a macro variable or characteristic that has been correlated with an asset class, market, or strategy. Simple examples of factor-based diversification include sensitivity to inflation or economic growth.  The alternative risk premium diversification may include sensitivities to value, size, term premium, or credit, among others. Some of them have proved to be moving and to fall out of favor.

A separate category of asset class/factor/risk premium diversification is the crisis-alpha type of strategy, which has low or negative correlation during "bad times". These scenario-based diversifiers could be safe assets or strategies that take advantage of market turbulence or diversification.

A final type of diversification is among managers who are alpha producers or who focus on short-term strategies that are not dependent on the overall longer-term direction of a market or risk factor. I will call this skill-based diversification. It can be hard to find, but it may prove stable relative to many macro-factor-based diversification strategies.

This taxonomy just scratches the surface of an issue that is fundamental to asset allocation and critical to maximizing portfolio return relative to risk. While portfolio diversification is often called the only free lunch in investing, this freebie can be enhanced by considering the form of diversification across scenarios.