Diversification with liquid alternative strategies: More than a free lunch

Diversification is the only free lunch that exists on financial markets. That’s why alternative assets absolutely belong in a balanced portfolio. So far, so good. But there’s more behind this common stock-market saying and this word of advice from Investing 101 than one would think. That’s because, like the compound interest effect, the act of combining a variety of uncorrelated hedge fund strategies is a small investment miracle that adds value to an investor’s portfolio precisely in times of richly valued equity markets and geopolitical uncertainty.

The free lunch theory

“There is no such thing as a free lunch,” asserted Nobel laureate Harry M. Markowitz, the father of modern portfolio theory (MPT). The wording modification “diversification is the only free lunch (in investing),” on the other hand, is not a quote, but rather a dictum from the school of MPT that was widely popularized by practitioners of the theory (Merton, Sharpe, Statman, Bernstein, Swensen et al.) and by financial economists. That dictum, in essence, has to do with the discovery that diversification can reduce portfolio risk without lowering the portfolio’s expected return. One therefore doesn’t have to pay a “price” in the form of sacrificed returns. In the case of a pure equity portfolio, (idiosyncratic) single-stock risk can be reduced “for free,” for example, by investing not in five, but in 50 or even 500 stocks. By doing that, one doesn’t forgo any expected returns, but merely eliminates “unnecessary” risk. However, the (systematic) market risk of an equity investment – i.e. price fluctuations due to changes in interest rates, recessions, or geopolitical shocks – cannot be completely eradicated by diversifying across numerous individual stocks. That is the price one pays for investing (and for the resulting return).

In the world of Markowitz, the added value of diversification is usually illustrated with the aid of the efficient frontier. For any given return, there is always a portfolio with minimum risk, or minimum volatility. A poorly diversified portfolio lies below the efficient frontier and contains more risk than is actually necessary. By diversifying, one gets closer to the efficient frontier and improves a portfolio’s risk/return ratio without incurring additional costs. If one adds alternative assets (gold, real estate, hedge funds) to a classic portfolio of stocks and bonds, one can even shift the efficient frontier upward so that an additional efficiency gain – i.e. the same return in exchange for less risk – can be achieved. However, since investors ordinarily blend in liquid alternatives only in small doses (seldom exceeding 10% of a total portfolio), this beneficial effect is usually limited. The benefits of diversification often are not exploited to the full.

Greater return and/or less risk | Diversification makes it possible

Shifting of efficient frontier by blending in hedge funds (liquid alternatives)

Source: Kaiser Partner Privatbank

Correlations are crucial

In order to improve the risk/return attributes of a portfolio through diversification, only one condition needs to be met: the combined assets must not be perfectly correlated, meaning that their prices must not all move in the same direction at the same time (correlation = 1). The lower the correlation between asset A and asset B, the greater the diversification effect (in the form of decreasing portfolio volatility and smaller drawdowns during correction phases). The biggest effect is generated by a correlation of –1, which exists when asset A and asset B always move in opposite directions (i.e. when A zigs, B zags). In the case of a pure equity portfolio, it is therefore better to combine stocks from different cyclical and defensive sectors (e.g. banking, technology, healthcare, utilities) than to bet everything on the Magnificent Seven, which frequently move synchronously, reducing the diversification effect.

However, the diversification effect of a widely spread basket of stocks also has limits. During periods of stress, correlations between normally uncorrelated equity sectors frequently spike. In those instances, diversification routinely stops working right when it is needed most. For a long time, the solution to this problem was a classic mixed portfolio composed of stocks and bonds. The idea behind it is that the two asset classes are inversely correlated, i.e. when stocks lose value, bonds act as a parachute for the portfolio because their prices rise right at that same time. That’s why a 60/40 portfolio (composed 60% of stocks and 40% of bonds) is considered a sound, diversified investment standard, particularly in the USA. So, it was all the more surprising for many investors when in the year 2022, the correlation between stocks and bonds turned positive and both asset classes suddenly trended downward concurrently. Those who probingly researched that occurrence discovered that the period between 2000 and 2020 was possibly an anomaly because in the decades prior, stocks and bonds were positively correlated and a simple mixed portfolio was less resistant to price downturns on the equity market.

A nasty surprise | The bond parachute failed to deploy during the last bear market

Equities, bonds and the 60/40 portfolio

Sources: Bloomberg, Kaiser Partner Privatbank

This is precisely where liquid alternatives and hedge funds come into play. Beneath this umbrella term, which unjustly often carries a somewhat negative connotation, there’s a wide variety of investment strategies that all have one thing in common: they all try to earn a return as independent as possible from the performance of the (stock) market. Depending on the strategy, the return’s correlation with the equity market lies in moderately positive territory (e.g. macro: approx. 0.3 to 0.5), close to zero (e.g. equity long/short market-neutral), or even in mildly negative territory (e.g. arbitrage and quant: approx. –0.3 to –0.1). If those correlations hold steady even during periods of stress on the financial market, hedge funds live up to their name and hedge an investment portfolio against price drawdowns.

Alpha instead of beta… | …and added value instead of risk

Potential hedge fund strategies within a multi-strategy portfolio

Source: Kaiser Partner Privatbank

The ninth wonder of the world

But it gets even better. Since many hedge fund strategies exhibit moderate to low correlations also between each other, combining them in a multi-strategy portfolio brings about a small investment miracle. The total return of the portfolio is equal to the average of the combined strategy returns, as one would expect. What one might find surprising, however, is the diversification effect: the volatility of the multi-strategy portfolio and its maximum drawdown decrease compared to the average of the individual strategies, considerably in some instances. The risk-adjusted return of the overall portfolio gets greatly improved and is frequently much better than the risk/return ratios for the individual strategies would lead one to presume. On the performance chart of a multi-strategy portfolio of that kind, this results in a line that trends upward without any major setbacks occurring and which lets an investor sleep easy amid any weather condition on the financial market.

1 + 1 = 3 | Combining low-correlated strategies leads to impressive outcomes

Sources: Bloomberg, Kaiser Partner Privatbank

A good time for liquid alternatives

So, such a portfolio of liquid alternative strategies can (and should) be more than a homeopathically dosed additive to a standard portfolio. In fact, a portfolio of liquid alternative strategies is a full-fledged (all-weather) investment strategy in itself. Speaking of the weather, the weather conditions for hedge funds and, by extension, the case for a larger allocation to liquid alternatives have improved on two counts. For one thing, the alpha winter of the 2010s decade is over. Those years marked by globalization, chronic intervention by central banks (ultralow interest rates and quantitative easing), and low volatility on financial markets were a drought period for hedge funds resulting in disappointing performance. But under the new market regime of the 2020s shaped by regionalization, elevated geopolitical uncertainty, higher interest rates, and increased volatility, opportunities for hedge fund managers have boomed – the good performance figures of the last five years, during which the top quartile of (multi-strategy) hedge funds earned double-digit percent annual returns, already reflects the improved climate.

Alpha spring | Equity-like returns have become possible again

Net performance of hedge funds by category

Sources: Aurum, Kaiser Partner Privatbank

For another thing, at the same time the longer-term prospects for the equity market have dimmed, at least if the “rules” of the past also apply to the future. Although the valuation of the stock market is not a good timing tool in the short run, over the long term it has consistently been a reliable indicator of performance over the next ten years. At the start of 2026, this specifically means that in light of the current price-to-earnings multiple of 22x for the (US) stock market, only marginally positive equity returns at best are to be expected over the next decade, and real returns (after subtracting inflation) are particularly likely to be disappointing. Diversifying into lower-valued non-US equity markets can help to alleviate this “investment problem,” but a multi-strategy portfolio composed of liquid alternatives may be an even better way to continue to earn equity-like returns with nerve-soothing low volatility in the years ahead regardless of the performance of financial markets.

Anything is possible in the short term… | …but equity markets are likely to disappoint in the long run

Correlation of equity valuation with future returns

Sources: Bloomberg, Kaiser Partner Privatbank