During the years preceding the financial crisis, the political and economic trends had the unintended effect of increasing the correlations between asset classes. The European Union’s mission was an “ever-closer union”. By removing barriers to trade; harmonising laws and regulations; and introducing a common currency, the EU was creating a single market.
While this crusade was largely beneficial in increasing economic efficiency and reducing costs, an underappreciated side effect was that the opportunities to diversify were being whittled away. An economic event that might have produced a wide range of responses across different markets a decade or two ago had a much more uniform impact on markets as economies converged.
Of course, this convergence wasn’t limited to just Europe. The conditions that led to the credit crisis were truly global in nature. The abundance of liquidity, lax lending standards, securitisation and the property boom were worldwide phenomena during the mid-2000s. Global financial markets knew no borders, and thus their fates were tied tightly together. Diversification options were becoming scarcer, but as equity and property markets boomed, no one seemed to mind until it was too late.
Today, investors are returning to the original intent of diversification: owning investments that truly behave differently. The opportunity set of potential investments has expanded to include entirely new asset classes once considered too exotic. Hedge funds, currency strategies, commodities, real estate, precious metals and emerging market debt are all part of the portfolio conversation these days. Pushing the envelope, asset classes like private equity, farmland, timberland, infrastructure projects, water rights and carbon emission rights are potential investments for certain risk profiles.
Such investments are not for suitable for everyone. These alternative asset classes carry unique and sometimes underappreciated risks. Liquidity risk or political risk might not show up in measures of volatility, but it could be the primary source of risk in these asset classes. Information is much harder to acquire and interpret; traditional valuation models might not apply. Truly understanding these asset classes requires investors to think about their investment differently. However, that’s the point of these new asset classes: their risks are idiosyncratic and not systemic. This is how you achieve diversification.