Anyone trying to build a good portfolio should take note that asset classes such as real estate and high-yield corporates that are often touted as being good diversifiers might not live up to the hype, according to Morningstar.

What is more certain is that the longstanding plain vanilla 60/40 portfolio, which has gotten its fair share of criticisms in recent years, might still be the standard for portfolio diversification, analysts at the research company say.

Amy Arnott, portfolio strategist and lead author of a recent report, "Explore Portfolio Diversification Strategies," said in a webinar last week that, during the market rebound on the equity side last year, a plain 60/40 portfolio beat a 60/40 portfolio with a more diversified mix of allocations by four percentage points.

In the analysis, the diversified 60/40 portfolio included 11 different asset classes, including emerging markets, commodities, high-yield bonds and real estate.

While the more diversified portfolio proved helpful during the bear market in 2022, it still lost about three percentage points, Arnott said. The webinar included colleagues Christine Benz, director of personal finance and retirement planning, and Karen Zaya, senior manager, research analyst, both of whom also were involved in the research.

Arnott noted that over a rolling 10-year performance going back to 1976, the more diversified portfolio did often help improve returns versus a stock-only portfolio. “But actively, the basic 60/40 had an even better record of improving risk-adjusted returns going back over those rolling 10-year periods,” she said.

The continued strength of the U.S. market might have investors losing faith in why they should own other asset classes, Benz said. Arnott agreed, saying that those who focused on performance over the past 15 years owned only U.S. stocks and have had good results. But value and small-cap stocks are also viable options, she said.

Arnott said historial data shows that there are times when U.S. stocks are outperformed by other asset classes. For example, she pointed out that in the late 1970s and 1980s and a period between 2002 and 2008, the non-U.S. market pulled ahead of the U.S. market, which made international stocks “useful, especially as a hedge against any potential weakness in the dollar.”

She also pointed out that non-U.S. stocks make up 40% of global market cap. “If you ignore international stocks, you would be leaving out a big and important part of the market,” she said.

While 2022 was a difficult year in the bond market, Benz remains somewhat bullish on fixed income as a diversifier. The 2022 environment, she said, was an indication of holding cash. “I’m a believer, especially in people who are actively drawing from their portfolios in retirement, that they should hold at least some cash,” Benz said. “Cash came sailing through 2022 with flying colors because yields went up, so that cash investor was a beneficiary in that environment.”

As for bonds, she said, when equities are under stress, “we have seen bonds perform quite well. ... The Feds is often lowering rates in that recessionary environment when stocks drop, and Treasury bonds are often seen as a place to be and a flight to quality,” she said.  “I would keep the faith. I would just be careful about where I invest my bond assets.”

As for commodities, Zaya noted that the "Bloomberg commodities Index returned around 16% in 2022 and the Morningstar U.S. market Index was about 19%, and in 2023, commodities were almost down 8% while the equity index was up about 26%."

Zaya said commodities are not the easiest to hold because their performance varies within a broad basket. Gold in general, she said, would be best for diversification to protect against market drawdowns, along with copper. But she recommended a broad basket of commodities in an inflationary environment.

Benz said high-yield bonds and bank-loan investments have not performed well as diversifiers. “In fact, performance tends to sort of fall between stocks and bonds and in a big equity market shock, they’ll typically fall in  sympathy with stocks,” she said.

On the tax-exempt front of fixed income, Benz said municipal bonds have been OK diversifiers, about in line with intermediate core plus bonds, but not as good as Treasurys, which she said “are liquid investments and tend be the beneficiaries in a flight to quality in a way that munis just aren’t.”  But munis, she said, are fine holdings for the higher-taxed investors who have assets in their taxable accounts and are looking to mitigate their tax exposure.

In terms of sectors that have stood out as good diversifiers, Benz cited energy and utilities. Energy, she said, was surprisingly strong over the past three years “because there have been periods where energy has been a little less compelling as a diversifier.” And “utilities continue to look halfway decent as a diversifier for a broad marketing index  and that has been a more persistent trend over the past few runs of the research,” she added.

Conversely, the technology and real estate sectors disappoint, she said. The technology sector, Benz noted,  has been pacing the U.S. market and there is no need for additional technology exposure if you have a broad U.S. market index, which includes many of the big technology giants at the top of many portfolios, she said.

Real estate was cited as another sector that has seen diminished value as a diversifier. Benz said that 20 years ago it was the go-to sector for counterbalancing equities. But performance has become much more closely correlated, she said. “There may be valuations or yield reasons at various points in time that investors want to emphasize in real estate, but from a correlation standpoint, it does not  seem to be  there in the data,” she said.

One area Arnott cautioned against diversifying a portfolio with is cryptocurrency, which she said has had very low correlation with almost every traditional asset class and should be viewed as a speculative investment. “But there is a very strong pattern where correlation tends to spike when the market is down, so even though you’re getting theoretical diversification benefit, you might not be getting that at all when you need it the most,” she said.

Arnott downplayed any inflationary benefits of bitcoin, noting that a lot of people talk about bitcoin as digital gold because there is a limited supply and should hold its value over time. “I think bitcoin ... during this bout of inflation has not worked at all as a hedge,” she said.

The report also examined factors which Arnott explained are another way of slicing and dicing the market. “The idea of factor-based investing is to really focus in on some of the main factors that a lot of investors use … like yield, momentum, quality,” she said.

Over a long period of time, she said, "we have seen an overall increase in correlations for most equity factors, which means you are not necessarily getting as much of a diversification benefit on investing based on factors as you used to." She attributed that to the many investors who are using factors as part of their investment.

The bottom line, Arnott said, is that diversification is a core principle of sound investing. “It goes back to the idea of not putting all your eggs in one basket.”

Advisors, she said, can add value to their client relationships by emphasizing that it’s impossible to predict which asset class is going to perform best or worst and that’s why it's important to hold a variety of asset classes.