Clients have learned a painful lesson over the past year about the risks of a widespread financial crisis. Those who believed they were sitting on a well-diversified portfolio found out that what works just fine under typical market conditions may not work that well when things go off the rails. As a result, clients may have to look further afield for alternative assets to help prepare them for the next big meltdown.

A cornerstone of many well-constructed portfolios is diversification; the theory is that inves-tors can earn more predictable, risk-adjusted returns by holding a selection of non-correlated assets. Consider the proverbial investor who has all of his or her eggs in one basket: if a portfolio has just a single asset in it, its gain or loss is entirely dictated by the returns delivered by that lone asset. So, to the extent that investors can add assets that generally produce divergent returns, they should be able to improve returns for a given level of risk. The expectation is that when one asset is underperforming, another type of asset will be outperforming, thereby smoothing out the highs and lows that individual assets may generate, protecting against major losses, preserving capital and delivering better returns overall to the portfolio.

In general, diversification does this job. And since it essentially costs nothing to employ such a strategy, it can be considered one of the investing world’s few genuine, free lunches. So, clients who thought they were being clever in diversifying their holdings by asset type, geography and market sector may have expected that their portfolios would hold up relatively well even in a market downturn. However, this latest market meltdown was so comprehensive that many clients found they were hardly protected at all.

The problem is that when markets get extreme, theories tend to fail; a fundamental component of diversification was quickly compromised by the recent crisis.

For diversification to work as intended, your clients need to understand the concept of correlation among asset classes. For instance, assets that are typically highly correlated — they do well at the same time in the economic cycle, and do poorly at the same time — don’t offer much diversification benefit. Holding assets that are generally non-correlated is the necessary condition for effective diversification.

The trouble is that return correlations can shift. And, with the occurrence of a synchronized worldwide financial crisis, clients have discovered that many assets can become highly correlated — and very quickly. As fear permeates markets and risk aversion spikes, all sorts of assets come under intense selling pressure, and their values can plunge at the same time. The result is that portfolios that once looked diversified perform as if they aren’t.

The obvious solution for clients who are looking to bulletproof their portfolios is to try to find assets that won’t necessarily see their returns become abruptly correlated in a time of crisis. But that’s much easier said than done.

In the latest crisis, very few assets managed to produce positive returns. Only the traditional safe havens such as gold, U.S. Treasury bonds and government bonds avoided negative returns.

Hedge funds, which are supposed to be able to prosper regardless of the overall market direction, had one of their worst years ever; many of their strategies were undermined by the crisis. Real estate was at the heart of the crisis to begin with, so it didn’t offer any salvation. Commodities were thumped as the financial crisis spilled over to the real economy, and the resulting recession dimmed the demand outlook for these assets. And private equity, which is supposed to have a longer time horizon that will insulate it from the short-term demands of the public markets, couldn’t escape.

But markets can’t stay in crisis forever. While diversification strategies may have failed in the face of an extreme meltdown, they should work once again as markets return to more normal conditions.

However, it’s not clear just when that will be. Notwithstanding the fact that fears of a complete financial system collapse have receded, securities markets remain under stress. With that in mind, your clients may want to consider incorporating more of these so-called “alternative” asset classes into their portfolios. As Michael Cooke, vice president of alternative strategies at Invesco Trimark Ltd. in Toronto, told a recent financial advisor conference: if volatility continues, alternative assets can be expected to provide diversification.

@page_break@That’s the strategy being pursued by the so-called “smart money” — institutional investors. According to research from Connecticut-based Greenwich Associates, despite the failure of diversification to provide much protection during the recent financial crisis, “institutions are sticking with diversification strategies.” The survey found that through the second half of 2008 and the first half of 2009, institutions were reducing their exposure to equities and maintaining significant allocations to hedge funds, private equity and other alternative investments.

The Organization for Economic Co-operation and Development also reports that pension funds have not backed off from their diversification efforts of the past few years. That includes increasing international equities diversification and maintaining exposure to hedge funds, private equity and infrastructure investments.

Cooke points out that retail investors can incorporate these sorts of non-traditional assets into their portfolios through products such as exchange-traded funds and traditional mutual funds that offer exposure to commodities, hedge strategies or real estate assets.

Although investment funds and ETFs impose management costs that reduce returns, they also provide retail investors with access to underlying assets that may otherwise be tough to acquire; and these funds do so via vehicles that offer some liquidity, which can also be scarce with direct investments in these kinds of underlying assets.

Nevertheless, your clients should not forget that alternative assets failed to provide much diversification in this latest crisis, and they may fail yet again in the next one. Indeed, as a recent report from Morgan Stanley Inc. notes: “Alternative assets often offer little if any refuge” as market correlations typically spike upward in a crisis. IE