Diversification: The answer for volatile markets

Throughout the first half of the year, investors had to contend with a rise in protectionist measures, threats of significant tariffs, an escalating global trade war, and mounting worries over economic growth.

A “what’s next?” feeling among investors fueled big swings in the stock and bond markets. The S&P 500 Index shed more than 4% in the first quarter. During a two-week stretch in March and April, yields on 10-year Treasuries fell roughly 50 basis points before rocketing more than 70 points higher. Stocks roared back in the second quarter as investors had more clarity on the economic impact of US-imposed tariffs. What was a decidedly risk-off market suddenly turned risk-on.

These types of uncertain economic and market environments are tough for any investor. For public and Taft-Hartley pension plans with looming liability payments and long-term funding ratios to consider, worries about “what’s next?” can be especially acute. While it may be tempting to quickly pivot to safety during volatile and uncertain environments, another option for public and Taft-Hartley plans is to get back to the basics—including making sure their plan is appropriately diversified.

Indeed, after years of benefiting from a concentrated market environment, investors today need to recognize the critically important role of diversification. A well-diversified portfolio strategy not only softens the impact of volatile markets but also affords more flexibility to take advantage of the opportunities these environments can produce.

Volatility is never far away

The factors driving today’s market environment are certainly unique, but these periods of uncertainty and volatility aren’t uncommon.

Consider the events of the past three years. During the post-COVID recovery period in 2022, rising interest rates and inflation caused sharp sell-offs in both the equity and fixed income markets. In that environment, institutional investors with strong cash positions were able to seek the safety of TIPS and real assets such as gold without needing to sell underperforming assets.

As markets rebounded in 2023, plans that rotated out of safe havens likely benefited from strong equity returns. Those that maintained a diversified approach, however, also benefited from the continued strength of TIPS and gold—even as the path of inflation continued to trend lower. In fact, in the two years through early July, gold spot prices have risen more than 70%, handily outpacing the S&P 500.

Last year, investors wrestled with several bouts of volatility, including a particularly sharp spike in equity market volatility in early August. That episode was fueled by worries about restrictive monetary policy, a deteriorating labor market, and the looming potential for higher tariffs from a new presidential administration.

Public and Taft-Hartley plans that stuck with a risk-on approach likely felt the pain of that volatile period, as the S&P 500 tumbled 6% in three trading days through August 5, while the index’s tech stocks fell 8%. By contrast, plans that pivoted to a more defensive posture may have diluted their exposure to a rebound in which the S&P rose over 14% between August 5 and the end of the year, led by a more than 34% gain from consumer discretionary stocks.

The power of planning

Improving sentiment around equities has led many institutional investors back to a risk-on stance. But this is precisely the time when plans should be thinking about how to handle the next bout of market volatility.

The first step in building an all-weather plan involves carefully evaluating the plan’s asset allocation with an eye toward diversification. Do plan managers understand what every exposure in their portfolio is delivering to the plan’s overall risk and return profile? Are there gaps in those exposures or areas of overconcentration?

Cash also should be an important area of focus: Institutional investors that do well in uncertain markets often have the ability to allocate to cash—and have a well-laid plan to manage that cash. That allocation can support strategic portfolio moves without the need to sell other assets. And as exposure to private market assets continues to rise among public and Taft-Hartley plans, sources of liquidity such as cash can help plans manage challenging market environments.

Plans may also want to consider strategies to add diversification through fixed income investments. This might include systematic active fixed income strategies that can deliver potential alpha, low benchmark tracking error, and low correlations to fundamental active strategies. Meanwhile, emerging market debt can not only provide attractive yield opportunities but also add a layer of diversification due to the different set of economic risks and opportunities emerging markets face compared to US debt.

In reviewing asset allocation strategies, it’s critical for plans to be aware of their investment time horizon. For instance, it may make sense to take a more defensive approach if a plan has specific short-term liabilities or obligations. Plans with longer-term horizons may have more appetite for risk even in uncertain markets. That said, liquidity still matters: Without it, for example, plans have less latitude to take advantage of buying opportunities when growth assets dip.

You can’t predict when volatility will reappear, but you can plan for its inevitable return. At State Street Investment Management, we have deep experience partnering with public and Taft-Hartley plan clients to consider key questions around portfolio positioning, asset allocation, and diversification. The goal is to identify strategies that give their plans the flexibility to manage risk and embrace opportunities in uncertain and volatile markets.