In the investing world, diversification is often treated as a checkbox—something to do, but not deeply understood. Yet, as Kadmiel Onodje and Kyan Nafissi of Boston-based NEPC’s Diversifying Strategies team argue, the right diversifying strategies are far more than portfolio decoration. They are portfolio defense, stabilizers, and strategic reserves, especially in a world where traditional stock-bond correlations no longer behave predictably.
In their December 2024 paper, “Choosing the Right Diversifying Strategies for Your Portfolio,” Onodje and Nafissi deliver a sophisticated blueprint for how institutional investors can use low-correlation strategies—not just to survive volatility, but to capitalize on it. “A diversifying allocation is meant to complete portfolio construction, not compete with the return-seeking portion of the total portfolio,” they assert.
Let’s unpack the key ideas, tactics, and portfolio construction insights embedded in this remarkably prescriptive guide.
Beyond the 60/40: The Case for Complementary Risk Exposure
Historically, the 60/40 portfolio served as a workhorse strategy. But recent years—especially 2022—revealed its frailty when both equities and bonds suffered drawdowns in tandem. “Fixed income could play similar roles,” the authors note, “but stock/bond correlation has not been predictable historically… As recently as 2022, bond and equity markets sold off, while many diversifying strategies such as multi-strategy, macro, and trend following emerged as winners”.
This breakdown in traditional diversification underscores NEPC’s central thesis: investors must retool their portfolios by introducing strategies that are uncorrelated or even inversely correlated to both public equity and fixed income exposures.
The Five Pillars of Diversifying Strategies
NEPC identifies five core approaches that, when combined, form a powerful diversifying allocation:
1. Global Macro
These strategies thrive on global dispersion—interest rate differentials, commodity shocks, geopolitical shifts. “Global macro can add protection to investor portfolios in volatile market environments,” they write, highlighting its “positive skew return profile”—small gains most of the time, large gains during stress.
2. Trend Following
By design, trend followers are divergent. They excel when markets move—whether up or down. “These strategies do well during periods of sustained bullish and/or bearish trends,” NEPC explains, cautioning that they may falter during sharp reversals or sideways markets.
3. Multi-Strategy and Fund-of-Hedge-Funds (FoHFs)
Multi-strategy funds, especially those using multi-portfolio-manager (multi-PM) platforms, offer a robust blend of alpha-seeking and risk-neutral strategies. “Strict risk controls are designed to force underlying portfolio managers to derive returns that are predominantly driven by idiosyncratic factors,” they explain. Still, they caution: these approaches come with high fees, leverage, and liquidity risk.
FoHFs, by contrast, provide more liquidity and access to closed managers but can suffer from over-diversification or firm instability. “Too much fundraising by a FoHFs manager can lead to dilution… overdiversification can pose a concern,” they note.
4. Event-Driven
These strategies seek return through catalysts—M&A, restructurings, bankruptcies. “Event-driven funds are opportunistic,” write Onodje and Nafissi. While more correlated to equities and credit, they can outperform during specific dislocations, particularly in volatile or transitional economic periods.
5. Relative Value Arbitrage
Often housed within multi-strategy funds, these techniques (like statistical arbitrage or dispersion trading) aim to strip out market beta and isolate anomalies. This approach “ratchets up the proportion of the funds’ return driven by idiosyncratic factors,” making them powerful diversifiers.
Customizing Diversification to Match Objectives
One of NEPC’s most important insights is that diversifying strategies can’t be one-size-fits-all. Portfolio sensitivities to growth, inflation, and liquidity should drive diversifying strategies allocations. For example, defined benefit plans may favour downside protection to stabilize funding ratios, while foundations may seek dry powder for opportunistic redeployment during selloffs.
The key, NEPC stresses, is customization: “Some [diversifying] strategies can produce positive returns in environments that negatively impact equities, fixed income, or both simultaneously”.
They advise segmenting diversifying strategies by directional vs. relative value exposures. “Broadly, approaches that generate profits and losses utilizing relative value trade structures are more diversifying,” they write. Trend-following is an exception—it is directional but still highly diversifying due to its unique pattern recognition and market-agnostic signals.
Practical Allocations: Three Sample Portfolio Mixes
To demonstrate implementation, NEPC presents three hypothetical diversifying allocations with varying objectives:
• Mix 1: Pure Diversification
50% discretionary macro, 50% systematic macro. Delivers the lowest beta to 60/40 and highest downside protection. Ideal for clients focused on defense.
• Mix 2: Balanced Diversification
Incorporates trend-following, macro, FoHFs, event-driven, and multi-strategy. Optimizes risk-adjusted return while preserving low correlation. NEPC believes this mix will suit the broadest range of clients.
• Mix 3: Return-Seeking Tilt
Heavier allocation to event-driven and multi-strategy. Offers greater upside but comes with moderately higher beta. Designed for clients willing to accept more directional risk for enhanced returns.
Critically, all three mixes outperformed a traditional 60/40 portfolio on a risk-adjusted basis over the sample period. And during crisis periods—2008, COVID, taper tantrum—each mix protected capital far better than traditional allocations.
Governance and Communication: A Final Word to Stakeholders
For CIOs, allocators, advisors, trustees, and investment committees, NEPC offers clear guidance: set expectations before market turbulence strikes.
“Investors should set these expectations at the inception of their diversifying strategies program in order to minimize emotional biases during periods of market drawdowns,” the authors advise.
A common pitfall? Benchmarking diversifying strategies to the S&P 500. “If investors are not clear around the beta and (low) correlation this allocation should have... they may build an allocation that they think is diversifying but ends up drawing down in a correlated fashion,” they warn.
Final Thought: From Concept to Completion
Kadmiel Onodje and Kyan Nafissi close with a clarifying reminder: “The most diversifying strategies utilize investment processes that produce returns driven by idiosyncratic risk rather than factor risk”. That’s the essence of a resilient portfolio—one that doesn’t just ride the market tide but remains composed, flexible, and opportunistic when others are not.
For institutional and everyday investors serious about risk-balanced returns and true resilience, NEPC’s all-weather framework offers more than just theory. It’s a practical, adaptable toolkit built to meet the moment—whether sunny skies or stormy seas lie ahead.
For further insights or portfolio construction consultations, NEPC encourages institutional allocators to engage directly with their investment consultants.
Footnotes:
1 NEPC, "Choosing The Right Diversifying Strategies for Your Portfolio." December 2024
