The rally was fuelled by a plethora of research from Wall Street firms, purporting to show the lack of historical correlation between stocks and commodities. What Wall Street forgot was that prior to this decade, investment in commodities was out of reach for most people, due to the complexity of the futures markets and difficulty in gaining the over-the-counter access required.

Then, exchange-traded funds came along, and suddenly investors could buy and sell commodities with the click of a mouse. By mid-2008, ETF investors had poured billions into commodities in just a few months. As the financial crisis worsened and stock and bond prices collapsed, ETF investors with margin calls to cover found it as easy to get out of commodities as anything else. As a result, the Dow Jones AIG Commodities Index plummeted 37 per cent in 2008.

“When people start buying an asset, the act of them diversifying ultimately makes the asset less of a diversifier,” summarises Pimco’s Bhansali. What happened to commodities also happened to tactical asset allocation, the Citi paper points out. “Through [the 1990s], tactical asset allocation was marginalised into futures overlay products, which were difficult to sell, given the inevitable episodes of underperformance elicited a cash call. Strategic asset allocation (SAA) in that period was left to the asset consultants, plan sponsors and product specialists. In recent years, the pendulum has shifted again, with multi-sector strategies enjoying a renaissance.”

In a client note earlier this year, Watson Wyatt warned funds to review the suitability of their existing SAA before rebalancing, following severely negative returns which left many funds substantially underweight to risky assets. “We think that it’s true that you should be focused on current conditions but we don’t think that means you abandon your long-term strategic asset allocation process,” says Ross Barry, head of portfolio construction at Watson Wyatt.

“As far as diversification goes, we don’t think that’s dead either, in fact we think the crisis serves to underscore the importance of genuine diversification. More specifically, the problem going into the crisis was that people didn’t appreciate how connected many of the markets are or can become in stressed conditions.”

In many cases, the crux of the problem lay in the lack of transparency within many of the so-called alternative structures being invested in. Without this transparency, funds were unable to understand the underlying sources of risk and return of their investments. “Three or four years ago we started to see, particularly within fund of hedge funds, that there were increasing exposures to leveraged credit and also to equity beta (equity market risk) in those portfolios,” Ross says.

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