Liquid Alternatives Can Diversify Portfolios—but Not All of Them Do

Alternatives have a hard time standing out in market environments in which market leadership changes and correlations shift amid short bursts of volatility and reversal.

That’s one of the key themes from our 2026 Diversification Landscape. In the report, Christine Benz, Amy Arnott, Jack Shannon, and I dedicate a section to looking at how alternative strategies have behaved alongside stocks and bonds and where they’ve delivered on their promise as diversifiers.

The bottom line: Liquid alternatives aren’t one thing. And whether they help a portfolio depends on what role they’re playing.

Here are five takeaways from recent markets that can help investors think about them more clearly.

Morningstar’s Guide to Portfolio Diversification

Takeaway 1: Not All ‘Alternatives’ Are Diversifiers

“Alternatives” is a broad label, but not all these strategies diversify a portfolio to the same degree.

Some of the biggest categories, like long-short equity and equity-hedged, still move closely with the stock market. Over the past three years, equity-hedged strategies maintained a correlation of about 0.98 with the Morningstar US Market Index, while long-short equity came in around 0.95. They can smooth the ride a bit, but they tend to rise and fall with equities. In practice, they behave more like toned-down equity exposure than true diversifiers.

Others, like equity market-neutral, systematic trend, and some macro strategies, look very different. They showed much lower, and sometimes even negative, correlation to stocks, helping reduce overall portfolio dependence on equity markets.

That difference matters more than most investors realize. A portfolio can look diversified on paper but still be heavily tied to equities underneath.

The takeaway: Don’t just allocate to “alternatives.” Know what job each strategy is doing.

Takeaway 2: Returns Matter—but They Need to Be Evaluated in Context

In a strong equity market, many alternatives will lag. That’s not a flaw; it’s by design.

Strategies built to reduce equity exposure or preserve capital won’t keep up when stocks are rallying. But that doesn’t mean they failed. It usually means they did exactly what they were supposed to do.

The more useful question is how they behaved relative to stocks and bonds. For example, equity market-neutral strategies maintained a roughly negative 0.18 correlation to equities over the past three years, meaning their returns were largely independent of the broader market. That kind of behavior can help offset equity-driven risk, even if absolute returns look less impressive in a strong market.

That trade-off, giving up some upside in exchange for different behavior, is where diversification comes from.

The takeaway: If you judge alternatives only by returns, you’ll miss their value. What matters is how they change the overall portfolio, preferably by reducing drawdowns and volatility with minimal return impact on returns over a longer time horizon.

Takeaway 3: Category Averages Don’t Tell the Full Story

Category-level results can look fine on the surface, but they don’t always reflect what investors experienced.

In some cases, average returns were pulled up by smaller or less widely held funds, while many of the largest strategies delivered more modest results. That gap between “average” and “investor experience” is easy to miss. The chart below provides some alternative category averages versus asset-weighted returns, which more likely represent the actual returns experienced by investors.

This shows up most clearly in areas like macro trading, where approaches vary widely, and outcomes can differ significantly from one fund to another; unfortunately for investors, the larger products often lagged.

The takeaway: The category label isn’t enough. Manager selection and implementation matter a lot more than the averages suggest with alternatives.

Takeaway 4: Diversification Doesn’t Show Up Every Year

Some alternative strategies only really shine in specific environments.

Trend-following is a good example. It tends to work best when markets move in sustained, clear directions, like in 2022. But in more choppy conditions, with frequent reversals and policy-driven swings, those signals break down, as they did in 2025.

Macro strategies face a similar challenge. They rely on identifiable trends across rates, currencies, and global markets. When those trends are less consistent, results can be uneven.

That doesn’t mean these strategies don’t work; it just means their benefits aren’t constant.

The takeaway: Diversification from alternatives is often episodic. You don’t always see it when you expect to.

Takeaway 5: Alternatives Didn’t Fail—They Just Didn’t Stand Out

It’s easy to look at 2025 and conclude that alternatives underperformed. But that’s largely because equities had a strong year.

Strategies with more equity exposure delivered the strongest returns. Those built to diversify or protect capital lagged. On the surface, that looks like a miss.

But lower returns were often the direct result of lower equity exposure, not a failure of the strategy. Equity market-neutral strategies, for example, returned 8.0% in 2025 while maintaining a negative 0.18 correlation to equities. That combination may not stand out in a strong equity market, but it reflects the role these strategies are designed to play.

Over time, many alternative categories maintained or even reduced their correlation to equities. In other words, they continued to do their job, just not in a way that stands out in a rising market.

The takeaway: Alternatives aren’t meant to win every year. They’re meant to make portfolios more resilient over time.

What This Means for Investors

The lesson from recent markets isn’t that investors need more alternatives—or that every strategy deserves a place in a portfolio.

In fact, the enduring strength of a simple stock-and-bond mix suggests most investors don’t need to look much further. A diversified core, built around US stocks, international stocks, and high-quality bonds, remains a solid foundation. For some, adding inflation protection through Treasury Inflation-Protected Securities may also make sense. Beyond that, additional complexity is often optional, not essential.

That doesn’t mean alternatives have no role. But they come with trade-offs.

Some strategies can reduce reliance on stocks and provide meaningful diversification. Others stay closely tied to equities but aim to smooth the ride. Both can be useful in the right context, but neither is a simple solution.

Many liquid alternatives are more complex than traditional funds. They often carry higher fees, can behave in ways that are harder to understand, and may not deliver consistent benefits year to year. In some cases, the diversification they provide may not be enough to justify those costs.

For investors, that means being selective. Alternatives are best viewed as targeted tools used to diversify, manage risk, or address specific gaps in a portfolio rather than as core building blocks. When used, they tend to be most effective in moderation and with a clear purpose.

Webinar note: My colleagues and I will be discussing these findings and other diversification strategies in an upcoming webinar on May 14, 2026.