In periods of positive stock/bond correlations, the case for diversified sources of return is much clearer. With stocks and bonds now showing their strongest positive correlation in almost 30 years, the natural diversification and risk protection that a traditional 60/40 portfolio offers is open to question. Meeting this challenge will require access to assets that are less dependent on the direction of the overall market, potentially via alternative investments such as direct lending, real estate debt, and macro hedge funds.
When looking at global capital markets over the last 50 years, one of the main observations is the changing correlation between stocks and bonds. Some periods show sustained positive correlation, while at other times it is negative. Over any extended period of time, we know the way that assets react to fundamental economic measures will change. Yet a core tenet of any investment framework is an enduring relationship between stocks and bonds.
This relationship between stock and bonds is a primary factor for assessing risk in an investor’s portfolio. In periods of negative correlation, investors can rely on the bond portion of their portfolio to function as a counterweight to equities. For example, when equity markets experience a decline, bonds would provide natural protection, and vice versa.

In fact, over much of the last 20 years, stocks and bonds were negatively correlated — providing the desired backdrop for an effective traditional 60/40 portfolio. But starting in 2018, the degree of negative correlation began to turn and, importantly, the diversification protection that bonds provided began to deteriorate. Stock/bond correlations turned positive in early 2022 (based on trailing 24-month returns), suggesting that stocks and bonds are now more likely to experience similar directional moves.
The implications of this shift are significant. If the traditional 60/40 portfolio no longer provides the key ingredients of a well-constructed portfolio — capital appreciation, downside protection, and portfolio diversification — investors may need to rethink and reshape their portfolios.
Planning for different investment backdrops
Depending on the composition of assets within a stock and bond portfolio, a traditional 60/40 allocation may not provide the risk profile or returns that investors expect. And while portfolio construction in a period of positive stock/bond correlation might be new to certain generations, the 1970s, ’80s, and ’90s experienced a similar trend.
During this period, stocks and bonds generally moved in the same direction. The U.S. economy experienced high and variable risk-free rates as well as high and variable inflation, although there were other economic and policy drivers.
It’s early to forecast whether the most recent phase of positive stock/bond correlation will prove to be short- or long-lived, but investors can plan for the possibility that what worked well over the last two decades may not necessarily work the same way moving forward. Stocks and bonds alone may not be able to fulfill the key portfolio goals of return generation, protection, and diversification.
For example, as stock/bond correlations began to turn positive in 2022, bonds experienced negative returns in each period when stocks suffered at least a 4% decline. Conversely, in the preceding 10 years when correlations were positive, bonds offered protection in periods of negative stock returns (Exhibit 2).

While the macroeconomic backdrop provides the fundamental components for the behavior of stocks, bonds, and other assets, it’s worth noting a few things in periods of positive correlation:
- Asset correlations can be driven by many factors, but at times of higher or more uncertain inflation, the correlation of stocks and bonds will more likely tend to be positive. Conversely, correlations tend to be negative in lower inflationary and growth environments.
- Changes in inflation can trigger similar directional behavior in stocks and bonds as rising inflation can depress real returns on bonds, and weigh on future earnings and multiples for stocks, and vice versa.
- If stocks and bonds remain positively correlated, each leg of the stool that comprises a well-constructed portfolio — capital appreciation, wealth preservation, and portfolio diversification — may be weakened.
Time to revisit the ‘re-correlation’ toolkit
Many investors may not have experienced a prolonged period when stocks and bonds were positively correlated. This backdrop may require a new mindset and has implications for portfolio construction. Finding ways to not just manage allocations but to expand the universe of investable options to alternative investments will likely become increasingly important in meeting long-term goals.
This may include certain “nondirectional” strategies that are less dependent upon the trajectory of the overall markets and are instead focused on exploiting its inefficiencies with an eye on downside protection. For opportunities beyond traditional stocks and bonds, we highlight direct lending, real estate debt, and macro hedge funds. These asset classes offer diversified sources of returns and low correlations to the traditional 60/40 allocation.
Direct Lending
Traditional fixed income investments have faced rising rates, higher inflation, and lower yields over the last two-plus years, creating challenges in managing the “40%” bond allocation in a traditional portfolio.
Direct lenders in the private market are reaping the rewards of higher absolute yields due to exposure to floating-rate securities, providing enhanced risk-adjusted returns. In addition, many direct loan facilities are secured and are senior in the capital structure, which provides defensive attributes against defaults. As it stands, it’s possible lenders could see yields over 12%. That’s largely because spreads right now fall between 550-700 basis points (bps) above the secured overnight financing rate base rate of 5.3%. At the same time, original issue discounts amortized over three years average 2%-3%.1
Due to these more stable total returns and defensive attributes, direct lending has been negatively correlated to the aggregate bond index, thus providing a complementary option to diversify fixed income allocations.

Real Estate Debt
Real estate debt offers stable, predictable income that generates regular cash yield for investors, helping provide additional sources of return and low correlation to other alternative investment asset classes.
Investment in real estate debt has been a topical debate. On one hand, the Fed’s rapid rate-raising campaign (525 bps increase between March 2022 and July 2023) has resulted in high interest expenses for existing borrowers and provided a catalyst for regional banks to pull back in their lending activities. And vacancies rates — primarily in office and retail — remain high. On the other hand, with the pullback in lending by regional banks, a leading source of capital to commercial real estate (CRE) borrowers, there are many opportunities for CRE debt funds to step in and provide capital, especially given higher rates and wider spreads.
Despite a complicated backdrop in CRE, it’s important to remember that the size of the commercial real estate market is often underappreciated — subcategories include multifamily, industrial, hotel, office, and retail assets. That means there are opportunities within the ecosystem even if the entire ecosystem isn’t optimally positioned.
Macro Hedge Funds
Macro hedge fund strategies — which seek to benefit from opportunities based on broad economic activity, political outcomes, and differing macroeconomic policies — have historically performed better during periods of higher interest rates, inflation uncertainty, and market volatility (Exhibit 4).

If history is a guide, elevated rates provide more opportunities for all hedge funds, including — and perhaps most conspicuously — strategies offering more diversification like global macro. Those funds in particular are skilled at adapting to changes in the landscapes of the major asset classes.
Macro strategies tend to have low correlations with the performance of traditional 60/40 portfolios, making them useful tools for absorbing the impact of market shocks. For example, during the noticeable downturn in equities from August to October 2023, the HFRI Macro Asset Weighted Index, a stand-in for macro strategies, was up 4.4% while the S&P 500 fell 8.6%.2
Conclusion
As ever, appropriate investment selection depends on an investor’s goals, risk tolerance, and liquidity needs, among many other factors. But for investors who are concerned with shifting stock/bond correlations, alternative investments can be an additive component of a portfolio that meets overall financial goals.
INDEX DEFINITIONS
Bloomberg U.S. Aggregate Bond Index: A broad-based, market-capitalization-weighted bond market index. The index includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds, and several foreign bonds traded in the United States.
S&P 500: The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 of the top companies in leading industries of the U.S. economy and covers approximately 80% of available market capitalization.
ENDNOTES
1. Federal Reserve Bank of New York, Dec. 13, 2023. 2. Bloomberg, HFRI, iCapital Investment Strategy, as of Dec. 7, 2023.
Author Biography:
Joseph Burns is a managing director and head of hedge fund research at iCapital. He focuses on the identification, selection, and due diligence of hedge funds. Before joining iCapital, Burns was chief operating officer at TCS Capital Management, a global equity hedge fund, where he focused on portfolio construction, risk management, and business development. Previously, Burns was co-CIO at Pulse Capital Partners, a seeding and accelerating asset management firm offering custom portfolio solutions for institutional clients. He holds a B.A. in political science from Manhattanville College and an MBA from Fordham University.
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