I listened to a number of presentations concerning crisis alpha and crisis offset at a recent hedge fund conference. The idea of holding assets and strategies that will do well in “bad times” is a critical issue for any portfolio construction discussion. It is the bedrock and foundation of any portfolio that attempts to protect against bad states of nature, control risk, and gain during good times.

There are two solutions that will mitigate negative return extremes in any crisis:

1. Diversification – Loses will always be less even if correlations increase during a crisis if there is a well- diversified portfolio in place. Nevertheless, diversification is not a “one size fits all” solution. The level and choice of diversification is an active decision no different than the choices made to increase return. Diversification is an active bet on correlation and volatility.

While not oversimplifying, different asset classes and strategies have different responses to “bad times” or crises. Hence, the cross-asset returns and correlations will change with the business cycle and with changes in the financial environment. If there is the expectation that crises are more likely, investors should be increased demand for assets that have characteristics of negative or low correlation during these states.

2. Momentum – Increase allocation to winners and cut exposures to losers. This is the simplest form of momentum. The next level of momentum trading is to short losers. Everything else could be considered just extra to portfolio construction. Of course, there are numerous ways of measuring winners and losers and there can be wrinkles based on forward expectations, but the concept is still very straight-forward. Momentum may not predict a crisis, but if a crisis occurs, momentum will help any investor to get on the right side of the market move. The adjustment from momentum occurs without even a clear view on the how or why a market declined. It is non-predictive and simply responsive to market forces. In a macro sense, momentum adds the equivalent of option gamma to the portfolio.

If you want to add an extra, do one thing:

Risk manage the portfolio – Allocate based on volatility (higher volatility tied to lower risk exposure). Target volatility so that if correlations move to one there is a cut in overall risk exposure. If the momentum signals will not adjust fast enough to market directional changes, then use stops to exit the market.

Asset management may not be that simple in reality, but it can be that simple in terms of guiding principles. If in doubt of what should be done in any situation, the guiding principles of diversification and momentum can serve as a first pass for construction.