Try Fund Library Premium
For Free with a 30 day trial!
Diversification across different investment asset classes sits as the foundation of portfolio construction. Combining different assets that behave differently in various market regimes provides greater portfolio stability and thus reduces both risk and the likelihood of making a behavioural mistake. We can all remember the 2000-2020 period that witnessed reliable negative correlations between equities and bonds, the cornerstones of most portfolios. And we can all remember the past few years when those correlations moved higher, causing greater portfolio volatility and making diversification harder to find.
One of the reasons correlations moved higher in recent years was the return of a higher inflationary environment. Inflation hasn’t gone away, but it has cooled enough for most central banks to gradually reduce short-term rates. The good news is that the strongly positive correlation between equities and bonds is starting to come back down. Just look at Canadian bonds – measured by the Bloomberg Canada Aggregate – which have declined for six months in a row, precisely what they’re supposed to do when equity markets are moving higher during this period. As a result, the one-year trailing correlation between Canadian equities and Canadian bonds has started to come back down.
We could celebrate this improving correlation trend, but it may be way too soon to pop the cork. Historically, when monetary policy (short-term rates) has been driven more by economic data, mainly focused on price stability, bond/equity correlations have been lower. And when monetary policy has been set more by other factors, correlations have been higher.
Over the past year in the U.S., the spread between actual Fed Funds rates and the Taylor rule has been much higher than normal. The Taylor rule is a guideline for short-term rates based on inflation and economic growth. Even today, the Taylor rule suggests a Fed Funds rate of 6%, a full 1.5% above the current rate. And there’s mounting pressure to cut short-term rates, despite the U.S. economy growing by over 3% and inflation remaining elevated.
The conclusion is that central bank policy is being driven by other factors outside the economic data. This is not an environment where we should expect bond/equity correlations to move back into negative territory, even though they are improving of late. We believe this also highlights the need to find diversification for portfolios from other sources. On this, there’s good and bad news.
The tools for constructing well-balanced portfolios have always evolved over time as different strategies with different performance characteristics continue to increase in availability. But correlations are not stable over time, and some investments that were great diversifiers can change to become less so. And if you wait long enough, older options may become great diversifiers once again.
Because of this evolving availability and shifting market correlations, diversifying across different asset classes remains prudent. Bonds were once great diversifiers, then not at all, and are now showing some signs of improvement. The good news is that there are other asset classes that have started to become better diversifiers than in years past, and some that have gone the other way. Here are a few examples:
The benefits of international equity diversification were extremely strong in the 1980s to 2000 as individual equity markets moved to their own beat. However, as markets became more intertwined, this diversification benefit softened, and then in 2019, correlations between markets were very strong. This greatly reduced the benefits of going more global in portfolios, from a diversification perspective.
However, this intermarket correlation has dramatically fallen in the past year. Across major equity indexes, the median correlation with the TSX has fallen to about 0.3, roughly the lowest correlation in the past 15 years. That certainly adds one more solid reason investors may benefit from increasing international diversification. And while a broad market selloff certainly drags down all markets, even during the turmoil earlier this year, there were material differences in the pain felt across different markets. Year-to-date performance at the global equity market bottom on April 8 had global equities down -12%, S&P -15%, TSX -9%, UK -3%, Germany +2%, and Hong Kong flat.
In a more polarized world, markets do appear to be diverging, and we believe this provides support for international diversification.
We’re just going to scratch the surface here and have our own disclaimer that, given the diversity of strategies in this space, any sort of aggregation insights have their limits. That being said, alternatives should be better. Scotia’s index is an equal-weight among hedge funds managed by Canadian-domiciled managers. The Liquid Alt line in the chart below is a large selection of liquid alts available in Canada (48) with very different strategies. This is the rolling median correlation among them vs the TSX.
The variance among different strategies is large. There are many that are great diversifiers against market risks, and there are many that are really just equity exposure with a few twists. A higher level of due diligence is required, and understanding a position’s purpose within a portfolio is critical.
We believe alternatives are certainly a source of diversification for portfolios, but with extra research and due diligence required.
There’s a general rule for Canadian portfolios: The U.S. dollar is great. History has shown that when there are periods of market weakness, the U.S. dollar often rises in value, providing a very valuable source of portfolio diversification. This happens for a few reasons. Most periods of market weakness can be traced back to concerns over economic growth. Given that the U.S. is less sensitive to global trade than other nations (including Canada), is the global reserve currency, and when trouble comes, many investors bring their money back home to America, the U.S. dollar tends to rise during times of trouble.
However, since recent central bank independence questions and policy uncertainty are homegrown in America, this diversification benefit is offset. So it’s not too surprising that, with the volatility of the past year, the U.S. dollar has not been a good diversifier. In fact, it’s been the opposite. Taking its place has been gold, which has done really well as a diversifier during periods of policy uncertainty.
We would say that bonds may not be as good a diversifier as during the previous decade, but they still do provide a reasonable amount. And given that yields are now higher, they also have more of a potential contribution to overall performance. The good news is that there are other sources of diversification from greater international allocations, alternatives, commodities, and even the U.S. dollar.
Choosing the right diversifier will really depend on what the next period of weakness looks like. If it’s a period of economic weakness, bonds and USD may work best; less so for gold and international. Or if it’s another flare-up in policy uncertainty, it could be the exact opposite.
Best to find diversification from a few key sources to best diversify your diversification.
Craig Basinger is the Chief Market Strategist at Purpose Investments Inc. and portfolio manager of several Purpose funds, including Purpose Tactical Thematic Fund.
Notes and disclaimer
Content copyright © 2025 by Purpose Investments Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Market Ethos“ page of the Purpose Investments’ website. Used with permission.
Charts are sourced from Bloomberg unless otherwise noted.
The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.
Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.
Image: iStock.com/Bogdan Pigulyak
Try Fund Library Premium
For Free with a 30 day trial!
Fund Library
