Most diversification strategies appeared to fail following the collapse of Lehman Brothers in September 2008 because investors did not sufficiently distinguish between risky assets and relatively safe assets such as US Treasury bonds, according to a recent analysis by Mellon Capital Management, part of BNY Mellon Asset Management.

Michael Ho, chief investment officer of Mellon Capital, said: “Traditional diversification did not provide the typical level of risk reduction during the 2008 financial crisis. One of the most frightening aspects of the 2008 crisis was that all risky assets sank in lockstep resulting in devastating losses. Our challenge is to craft a portfolio to withstand a perfect storm.”

The Mellon Capital study concluded that investors would fare better during a period of high volatility and low liquidity such as the financial crisis that began in September 2008 by tactically following a three-pronged program: actively reducing market exposure; making passive investments in assets that historically have done well in market shocks; and implementing strategies that historically have done well during increasing volatility.

The Mellon Capital study noted that picking the right moment to reduce market exposure depends on correctly anticipating whether the economy will be adversely affected by the market downturn, which can be difficult to determine by measuring volatility levels alone.

The paper noted treasury bonds performed especially well during flights to safety associated with previous spikes in equity volatility, and the 2008 episode conformed to this pattern. Traditional diversifiers such as commodities, real estate investment trusts and stocks have performed well only during periods of less-intensive shocks.

Strategies that tended to perform well during periods of increasing volatility include trend-following strategies, pure market-neutral strategies, statistical arbitrage, and high-frequency trading.