For financial professionals in Finland

Alternatives: when diversification doesn’t work, what do you do?

Market change demands a change in investors’ strategies. David Elms, Head of the Diversified Alternatives team, considers the options that alternatives offer when more traditional diversification strategies end up looking the same.

David Elms

David Elms

Head of Diversified Alternatives | Portfolio Manager

21 Oct 2022
6 minute read

Key takeaways:

  • The market environment has changed dramatically in just a few months, reflecting concerns about the energy crisis, supply chain issues and geopolitical uncertainty.
  • The rise of interest rates in response to inflationary pressures is a huge change for investors long used to what has been a very benign backdrop, posing questions about how today’s market might behave. This can present opportunities as well as potential pitfalls for investors.
  • What matters for such game-changing moments is strategies offering uncorrelated approaches and incorporating different forms of crisis alpha. This is where alternatives come into the picture.

2022, to date, has been a year of seismic change at every level, with profound consequences for everyone, not just financial markets. The risk of significant geopolitical escalation remains, whether that is between Russia and the western world or, more recently, China and the West over Taiwan. These are things that could be game changers for the world.

The inflation/interest rates conundrum

The ramp-up in interest rates this year, in response to inflation, is a huge change for investors long-since used to what has been a very benign environment. This has posed questions about what happens in a modern market environment, with modern investment techniques, where the pricing of risk is changing.

A good example is the role of bonds in a portfolio. The correlation between bonds and equities has been persistently negative since the late 1990s, with some exceptions. A traditional bond/equity portfolio has benefited from the natural risk offset created by that negative correlation. Bond yields were also at high enough levels that there was the potential for yields to go down in a crisis, creating capital gains that could stabilise a portfolio.

But in a low-yield environment, in inflationary times, the correlation between bond and equity prices is less certain, and your typical 60/40 portfolio is not going to look, or behave, in the same way as it has before. The question now is if we believe we are in a regime where inflation is likely to remain persistently above 2% in the economies we are focused on, the point at which the correlation between bonds and equities seems to become less certain, potentially flipping from negative (ie. diversifying) to positive (ie. correlative).

On the balance of probabilities, this scenario seems likely. The question then turns to how investors can potentially stabilise that ‘balanced’ portfolio. In our view, the current environment calls for broader thinking. This is where alternatives come into the picture.

Don’t look to the past for clues

If we go back to the 1970s, the most recent period that we had substantial increases in inflation, the market was a different place. The market participants were different, the role of retail was different, and the scale of hedge funds was very much smaller. It is a risky game to assume that market behaviour will follow the same path. But there are some strategies that we expect could still do well.

Trend-following strategies, for example, might offer part of the solution for investors. The US market was down almost 25% year-to-date to the end of September 2022. But while volatility has crept up, it has been a relatively orderly decline thus far, without the very sharp moves – up and down – that were present during the COVID crisis in 2020 (Exhibit 1). When you see a stable trend, you would expect trend-following strategies to stand out. Another attraction of trend-following strategies is that they are scalable and can be built at a reasonable cost for fee-sensitive investors. These are the characteristics that large-scale investors need.

Exhibit 1: Market falls in 2022 have not corresponded with higher uncertainty

Source: Janus Henderson Investors, Refinitiv Datastream, 31 December 2019 to 30 September 2022. Past performance does not predict future returns.
Note: The VIX Index is a real-time market index used as an indicator of the market’s expectations for volatility in the S&P 500 Index over the coming 30 days.

But trend following requires the right kind of market. If we go back to 2020, we saw the S&P500 Index lose a third of its value between 19 February and 23 March. Sentiment flipped suddenly and dramatically as the rapid spread and severity of COVID became apparent. In a similar environment, trend following could tend to struggle, given how fast asset prices moved.

“It’s tough to make predictions, especially about the future.” (various)

In crisis periods, assets become correlated. In other words, diversification works in normal market environments, when arguably it is not needed, but tends to fail in a crisis (with correlations trending to one) when its benefits are most needed. This is not necessarily because portfolio construction is broken, but rather because you tend to see herding from investors during periods of acute uncertainty. This herding behaviour is an intended consequence of modern risk management practices, which have a general focus on adjusting portfolio exposures in response to market volatility, and which have become prevalent over the past three decades, dating back to JP Morgan’s commercial launch of RiskMetrics in 1992.

For institutions such as banks, hedge funds and traditional asset managers, if the volatility of a portfolio is unacceptable, de-levering – selling long positions and covering short positions – is the common response. However, de-levering pushes prices down which can deepen the crisis. Volatility consequently goes up, which leads to more de-levering. This is known as a ‘value-at-risk’ spiral. In that environment, it is easy to see why diversification fails, because most investors are forced to liquidate by their risk management disciplines. What works at an individual level as a risk management tool has a tendency to exacerbate risk flare-ups when widely deployed across the industry.

When diversification doesn’t work, what do you do?

What matters for those game changing moments is to have a liquid portfolio with a range of different strategies offering uncorrelated approaches and incorporating different forms of crisis alpha, such as volatility strategies, trend-following and discretionary macro. So-called ‘protection’ strategies offering reverse polarity with regards to risk can be helpful when diversification is breaking down.

The counterargument is that paying for that peace of mind can create a drag on return over time, but we would argue that the shape of returns is as important as their simple magnitude. This shape can be vital to investors who are looking to retire, or those who can’t afford to risk a significant loss of value. It does not work for everyone. You need to consider what assets a client holds, what their liabilities are, and what their objectives are. But, given the scale of change and uncertainty markets have experienced over past few years, you have to ask yourself if you can afford to focus solely on return maximisation, without considering the benefits of risk management and protection strategies.


Bond yields – the level of income on a security, typically expressed as a percentage rate. For a bond, this is calculated as the coupon payment divided by the current bond price. Lower bond yields mean higher bond prices.

60/40 portfolio – a common structure for an investment portfolio, made of 60% equities and 40% bonds.

Alpha – A measure that can help determine whether an actively managed portfolio has added value in relation to risk taken relative to a benchmark index. A positive alpha indicates that a manager has added value. Alpha is the difference between a portfolio’s return and its benchmark’s return after adjusting for the level of risk taken.

Inflation –The rate at which the prices of goods and services are rising in an economy.

Hedge funds – Pooled investment funds that can invest in a wide range of strategies, depending on their remit, from traditional equities and bonds to a range of alternative strategies, real estate, cryptocurrency, etc, employing derivatives to hedge or leverage positions, plus other strategies, to deliver performance.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.


Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.


The information in this article does not qualify as an investment recommendation.


Marketing Communication.






Important information

Please read the following important information regarding funds related to this article.

The Janus Henderson Fund (the “Fund”) is a Luxembourg SICAV incorporated on 26 September 2000, managed by Janus Henderson Investors Europe S.A. Janus Henderson Investors Europe S.A. may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions.
    Specific risks
  • Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall. High yielding (non-investment grade) bonds are more speculative and more sensitive to adverse changes in market conditions.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
  • The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • The Fund involves a high level of buying and selling activity and as such will incur a higher level of transaction costs than a fund that trades less frequently. These transaction costs are in addition to the Fund's Ongoing Charges.
  • The Fund may invest in contingent convertible bonds (CoCos), which can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares of the issuer or to be partly or wholly written off.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • SPACs are shell companies set up to acquire businesses. They are complex and often lack the transparency of established companies, and therefore present greater risks to investors.