By Tom Lauricella (WSJ)

Carl Mahler stood before a group of fellow financial advisers recently and voiced frustration and fear that a fundamental tenet of investing had been proved wrong.

“Hi. My name is Carl, and I’m a recovering asset-allocationist,” the Raymond James Financial adviser quipped.

Asset allocation, a bedrock of investing for decades, appeared to fail miserably in 2008. The conviction shared by most investors — that they should spread their money across myriad asset classes to minimize losses — was shaken as nearly all markets tumbled in unison.

The financial crisis has sent many financial advisers, academics and investors back to the drawing board. Mr. Mahler told the group he was rewriting the playbook he had followed for much of his 41 years in the markets. “Asset allocation did not work,” he says. “Everything went into the abyss.”

Many investors came away from the carnage believing that last year was an anomaly — that, in times of severe stress like that experienced in 2008, disparate markets will all tumble together as investors scramble to sell whatever they can and move into cash.

But a number of influential investors and analysts, from managers of massive funds such as Pacific Investment Management Co., or Pimco, to those at small school endowments, argue that asset-allocation strategies are fundamentally flawed. This wasn’t a one-off failure, they say, but one that’s been long in the making.

“You were increasingly seeing a breakdown” of perceived relationships between asset classes, says Mohamed El-Erian, co-chief investment officer at Pimco. “And that was way before the latest phase in the markets, which accentuated the problems.”

Investors like Mr. El-Erian contend that the problems warrant rethinking those relationships to account for broad changes in the global economy and financial innovations that change the way people invest.

Not everyone agrees. Last month, Fidelity Investments issued a report to clients defending the strategy. “Diversification didn’t fail in the recent market downturn. It worked — just to a lesser degree,” the report said.

A Simple Concept

On the surface, diversification is a simple concept: Combine investments that don’t move up or down at the same time, or at least by the same degree. The goal is to smooth out returns, to hedge portfolios against big losses on single investments, and to position investors to benefit if one corner of the market posts outsize gains.

Diversification spawned a whole range of investment options. Among the most popular are target-date mutual funds, which offer a mix of stocks and bonds tailored to the investor’s age, wealth and risk tolerance. Some investors in these funds lost so much money last year that they would have been better off putting their money into a stock-index fund.

By the time the Standard & Poor’s 500 stock index hit its recent low on March 9 — a decline of 47% from a year earlier — nearly four dozen target-date funds had done even worse, including funds from Goldman Sachs Group, OppenheimerFunds and Alliance Bernstein. At Fidelity, one of the leaders in such funds, the Freedom 2050 Fund lost 48% in the 12 months ended March 9.

The theory of asset allocation emerged in the 1950s when economists such as Harry Markowitz, who would later win a Nobel Prize for his work, developed mathematical models for ways to improve investment portfolios.

Along the way, asset allocation became ingrained in nearly every corner of Wall Street. For brokers, tinkering with asset allocations was among the basket of services for which they charged clients flat fees year after year. Pension-fund consultants built a lucrative business screening money managers.

For mutual-fund companies, asset allocation was a cornerstone of their buy-and-hold philosophy, which helped them hang onto assets. They expanded their businesses beyond plain-vanilla stocks and bonds to funds that reaped higher fees. Target-date funds have become the centerpiece of most 401(k) plans.

Yet in recent years, while Wall Street was promoting diversification and formulas that purported to capitalize on it, the relationships among asset classes were changing. Investments that weren’t supposed to move in sync, such as stock markets on opposite sides of the globe, had begun moving in similar ways. That reduced the benefits of diversification through asset allocation.

Correlation is a statistical measure of the degree to which investment returns move together. Between 1991 and 1994, the correlation between the S&P 500 index and high-yield bonds was low, at 0.2 or 0.3, according to Pimco statistics. (A correlation of 1 means returns move in perfect sync.) International stocks had a correlation with the S&P 500 of 0.3 or 0.4, and real-estate investment trusts had a correlation of 0.3, according to Pimco data. Commodities showed little correlation to U.S. stocks.

By early 2008, investment categories of just about every stripe were moving significantly more in sync with the S&P 500. The correlation on international stocks and high-yield bonds rose to 0.7 or 0.8, and real-estate investment trusts to 0.6 or 0.7, according to Pimco’s data for the previous three years. Commodities were showing a slightly negative correlation — returns were moving in opposite direction — of 0.2 or 0.3, the data indicate.

Then came the meltdown of 2008. In a year when the S&P 500 lost 37%, the MSCI index of major markets in Europe, Asia and Australia lost 45%. The MSCI emerging-markets index fell 55%. Real-estate investment trusts declined 37%, high-yield bonds lost 26% and commodities fell 37%.

At Pimco, the firm’s head of analytics, Vineer Bhansali, points to commodities as an example of how diversification strategies can break down. Even as stocks and bonds struggled in early 2008, commodity prices were in the midst of a historic rally. Wall Street rolled out research showing the lack of correlation between stocks and commodities.

But that history didn’t take an important point into consideration. Prior to this decade, investing in commodities was a complicated process due to the complexity of the futures markets. The advent of exchange-traded mutual funds, or ETFs, allowed investors to buy and sell commodities with the click of a mouse. By the summer of 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 who needed to raise money found it easy to bail out of commodities, too. That contributed to a 37% drop for 2008 in the Dow Jones AIG Commodities Index.

“When people start buying an asset, the act of them diversifying ultimately makes the asset less of a diversifier,” says Pimco’s Mr. Bhansali.

Louis Morrell, who until this month oversaw Wake Forest University’s entire $1 billion endowment, felt this firsthand in the school’s portfolio.

A $90 million portion of the endowment, called the Tactical Fund and still managed by Mr. Morrell, held everything from commodities to emerging-market and big-cap stocks. Mr. Morrell, involved with money management since 1968, had honed a strategy based on the idea that you could have a portfolio filled with investments ordinarily considered risky and volatile — but if they didn’t move in sync, you could have higher returns without higher risk. For many years, it worked, even during bear markets. During 2001, for example, the Tactical Fund lost 0.1% while the S&P 500 dropped 15%.

Clobbered

Last June, the Tactical Fund had nearly 30% invested in commodities, 16% in emerging markets, 19% in other non-U.S. stocks, and 24% in U.S. stocks — investments that historically didn’t move much in tandem.

“We got clobbered,” he says. The Tactical Fund lost 44% last year and the overall endowment fell 25%. Late last year, he and his team began working on a new allocation strategy. Rather than treating large-cap U.S. stocks, emerging-market stocks and international stocks as separate categories, the team put them under one “stocks” umbrella. They also switched their view on commodities and gold, which they felt were linked more to inflation than to stocks.

The Tactical Fund still has a healthy slug of commodities as an inflation hedge, and emerging-market stocks now make up 24%. Corporate and government bonds account for 14% of the portfolio, down from 42% at the end of March. Thus far, the new approach is paying off. The Tactical Fund is up 14% this year, through Tuesday, compared to a 2.5% drop in the S&P 500.

“The old strategies were mathematically correct and gave a sense of a lot of discipline,” Mr. Morrell says. However, “they were too backward-looking.”

At Ibbotson Associates, a Chicago firm specializing in asset-allocation strategies for big investors such as pensions and mutual funds, chief economist Michele Gambera also has gone back to the drawing board. It’s been a topic on his mind for the past two years, he says, but 2008 heightened his scrutiny. “There have been reasons to question diversification, no doubt about that,” he says. “It’s been humbling.”

Mr. Gambera says a telling picture emerges by tracking performance during extreme market moves. He found that many investments can do more damage on the way down than they do good on the way up.

Since 1973, in months where U.S. stocks rose more than 6%, European stocks rose on average by three-quarters as much, and Japanese stocks by half as much, according to Ibbotson.

But when the U.S. market fell by more than 4.5% in a month, Europe and Japan tracked the declines far more closely. Stocks in Europe on average posted declines equaling 86% of the U.S. drop, and in Japan, 66%. Real-estate investment trusts matched about half of the U.S. market gains in the best scenarios, but two-thirds of the declines.

“Even if it’s important to add an investment for diversification, people have to consider the costs,” he says. “And we’re learning that there are a lot of implicit stock-market bets in a lot of asset classes.”

As Mr. Gambera sliced and diced the numbers, he concluded that only a few asset classes besides cash proved to repeatedly help a portfolio during a sharp decline. He determined that in the 45 months since 1973 where the U.S. stock market lost more than 4.5%, gold produced positive returns 71% of the time, and intermediate-term government bonds, 67% of the time. During the 20 big monthly declines for stocks since the launch in 1997 of Treasury Inflation Protected Securities — government bonds whose payout is adjusted for inflation — TIPS provided gains 85% of the time.

As a result, Mr. Gambera says, Ibbotson is now recommending bigger holdings of U.S. Treasurys for certain clients.

Hard Lesson

At Raymond James, Mr. Mahler also has retooled the way he builds portfolios. This was no easy decision, he says. Even after the bear market that ended in 2002, he didn’t make any changes to his models.

“It’s what I lived and breathed,” he says. He is keeping the basic structure of his portfolios, but he’s adding money managers with a go-anywhere mandate, including actively betting against stocks by going short.

He is coupling that with greater cash holdings in accounts. His goal is to make a portion of clients’ portfolios more flexible, while at the same providing a greater cushion for whenever stocks next decline.

He says he is convinced there is a way to make diversification work. In fact, after the strains of last year, he says, many investments are behaving more like they did before 2008.

Asset allocation, he says, “might well have been injured….But I don’t think it’s gone forever.”