Oil and water. That’s how most investors would describe the relationship between bonds and stocks. The two asset classes are often seen as key components within a portfolio due to their diversification benefits. When one zigs, the other zags. Bonds are owned to provide positive returns when stocks fall.
However, many investors would be hard-pressed to find out that correlations between stocks and bonds are often positive.
With that in mind, bonds’ role as diversifiers is being questioned, particularly with the rising volatility within the asset class. While bonds still have a place in modern portfolios as a source of non-correlated returns, they fall flat. In that case, their role as a diversification tool needs to be questioned by investors of all sizes.
Stocks, Bonds & Diversification
The main tenant of the modern portfolio theory (MPT) is that diversification of asset classes can deliver steady long-term returns. When one asset class moves one way, another will move the opposite. Together, they form positive returns across various market cycles. As such, modern portfolios cobble together baskets of investments to meet this need and balance risk. Historically, that’s been a mix of equities and bonds. Typically, at a 60/40 stock/bond allocation
The key to that relationship is a concept called correlation.
Correlation is basically the measure of the degree to which two securities move in relation to each other. Values for correlation fall within -1.0 and 1.0. Asset classes that move in the same direction will have positive correlations, while those that move in opposite directions will be negative.
For many portfolios and investors, bonds and stocks have been looked at as having negative correlations. That is, when stocks rise, bonds fall. The key is in the inverse; investors will rush into fixed income assets when the market gets dicey. The idea is the negative correlation will protect profiles and provide steady returns in good times and in bad.
Investors Have Short Memories
It’s true that bonds and stocks have had negative correlations during their histories together. The last time was the 2000s. Post dot-com crash and into the Great Recession, bonds moved negatively with regard to the broader equities markets. This helped drive the idea that bonds could be a diversifier for stocks.
But going back further in time and into modern history, the relationship falls flat. During the 1980s and 1990s, the relationship between bonds and stocks was completely positive. And since the Great Recession, the correlation relationship has flip-flopped constantly based on the market’s appetite for risk, inflation vs growth outlooks, and various other geopolitical trends. The lack of consistency is there.
However, since the Great Recession, the stock-bond correlation has oscillated based on whether the market has a palate for risk, whether investor concerns are tilting toward inflation or growth, or other trends, and has turned positive in many periods. Asset manager State Street (SSgA) has the skinny on this trend in actual data.
Since 1995, the average 12-month return correlation for stocks and bonds is -10%. This would indicate that the negative relationship is alive and well. However, digging into the data, SSgA shows that when looking at consecutive rolling 1-year daily observation periods, stocks/bonds have had more than 630 positive correlation periods. That’s a historical record. 1
Moreover, correlations are called into question when looking at stock/bond beta — or the sensitivity to overall market performance. Looking at a 60/40 portfolio’s beta, State Street says that beta is at the highest level in more than 15 years. Bonds’ beta has only increased — meaning both asset classes are now more “stimulated” by higher levels of overall market risk. This chart from the asset manager highlights this phenomenon.
Source: State Street
The question now is, what does this mean for portfolios? The short answer is that bonds may not provide the diversification investors seek.
With stocks and bonds returning to their old positive-correlated ways and flip-flopping between negative/positive on a dime, investors can’t count on them to provide the same level of diversification. If stocks zig, bonds may zig, too. That doesn’t mean they don’t have a place in portfolios. A positive correlation doesn’t mean that stocks and bonds will move in the same magnitude. Bonds do jump less than stocks, and their steady coupon payments do provide a safety net for portfolios. So, investors may not want to abandon the asset class altogether.
Looking Elsewhere
For State Street and a growing chorus of other analysts, the answer is to look beyond stocks/bonds for diversification benefits. Other asset classes can still provide non-correlated attributes to a portfolio. For SSgA, the answer lies within three asset classes- gold, commodities and alternative defensive equity strategies such as covered-calls.
These alternatives still provide a negative correlation to stocks, bonds, and a 60/40 split. For example, gold negatively correlates to stocks over the long haul, while commodities negatively correlate to bonds. Exposure to covered calls on the S&P 500 has historically had 15% less volatility and has provided 23% lesser average drawdowns than the broad index.
By adding these assets to a portfolio, investors can overcome the continued positive correlation exhibited by bonds to stocks and gain diversification benefits. Again, there’s nothing wrong with bonds, but investors need to shift their expectations on how they function within their portfolios.
The best part is that adding these asset classes is easy via ETFs. There are numerous funds that allow investors to quickly add these assets to a portfolio and change their 60/40 weightings accordingly.
Active Commodity ETFs
These ETFs were selected based on their active exposure to the commodities futures market. They are sorted by their YTD total returns, which range from 5.6% to 9.2%. They have expense ratios between 0.55% and 0.92% and assets under management between $10M and $350M. They are currently yielding between 3.4% and 8.6%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| HCOM | Hartford Schroders Commodity Strategy ETF | $10.1M | 9.2% | 4.1% | 0.67% | ETF | Yes |
| CMDT | PIMCO Commodity Strategy Active Exchange-Traded Fund | $349M | 8.7% | 8.6% | 0.92% | ETF | Yes |
| NBCM | Neuberger Berman Commodity Strategy ETF | $223M | 6.8% | 4.9% | 0.76% | ETF | Yes |
| PIT | VanEck Commodity Strategy ETF | $23.5M | 5.6% | 3.4% | 0.55% | ETF | Yes |
Active Derivative-Focused ETFs
These ETFs were selected based on their exposure to options overlays and derivative mandates. They are sorted by their YTD total returns, which range from -4.1% to 10.7%. They have expense ratios between 0.35% and 0.66% and assets under management between $145M and $40B. They are currently yielding between 5% and 11%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| IDVO | Amplify International Enhanced Dividend Income ETF | $145M | 10.7% | 5.9% | 0.66% | ETF | Yes |
| JEPI | JPMorgan Equity Premium Income ETF | $40B | 1.6% | 6.9% | 0.35% | ETF | Yes |
| DIVO | Amplify CWP Enhanced Dividend Income ETF | $3.89B | 0.7% | 5.0% | 0.56% | ETF | Yes |
| JEPQ | JPMorgan Nasdaq Equity Premium Income ETF | $23.4B | -4.1% | 11% | 0.35% | ETF | Yes |
Gold ETFs
These ETFs were selected based on their ability to provide access to physical gold at a low cost. They are sorted by their YTD total returns, which is around 15.6%, and none of them currently pay a dividend. They have assets under management of $928M to $75B and expenses of 0.09% to 0.40%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| IAU | iShares Gold Trust | $33.5B | 15.7% | 0% | 0.25% | ETF | No |
| GLDM | SPDR Gold MiniShares | $9.15B | 15.7% | 0% | 0.10% | ETF | No |
| IAUM | iShares Gold Trust Micro | $1.39B | 15.7% | 0% | 0.09% | ETF | No |
| OUNZ | VanEck Merk Gold Trust | $1.21B | 15.7% | 0% | 0.25% | ETF | No |
| AAAU | Goldman Sachs Physical Gold ETF | $928M | 15.7% | 0% | 0.18% | ETF | No |
| GLD | SPDR® GOLD TRUST | $74.9B | 15.6% | 0% | 0.40% | ETF | No |
In the end, the relationship between stocks and bonds has mostly always been positive. For investors, this challenges all the thinking around diversification and building a modern portfolio. With correlations staying positive, investors need to look for additional sources of diversification. Alternatives such as gold, commodities, and option-based returns could be the answer.
Bottom Line
Bonds and stocks are thought of as being like oil and water. Not mixing and providing plenty of diversification benefits. However, the reality is that they are positively correlated. And that creates a different need for diversification in a portfolio.
1 State Street (January 2025). Rethinking the Role of Bonds in Multi-Asset Portfolios
2 State Street (December 2024). Diversify Portfolios With Alternatives
