2025 Fall Investment Directions: Rethinking diversification

Updated as of 10/30/25

Exposures for today's market

Key takeaways

• Portfolios today tend to be riskier overall because of significant changes to foundational relationships,¹ including stock/bond correlations and the increasing concentration of U.S. indexes because of the rise of AI.
• We believe today’s regime – which has undermined traditional diversification benefits –may endure due to key factors such as persistent inflation dynamics, policy action and fiscal imbalances.
• Investor sentiment has remained robust despite ongoing macroeconomic and geopolitical uncertainty. We are already seeing portfolio shifts as investors accelerate how they’re diversifying with alternatives and commodities, and reallocating away from cash.

Fixed Income

• As correlations diverge, investors have been shifting bond portfolio composition away from the long end of the yield curve. With the Fed easing cycle underway, we maintain our highest preference for income, where we see attractive all-in yield with limited duration risks. We prefer sourcing duration from the 3- to 7-year ‘belly’ of the curve.

U.S. Equities

• Our view supports a preference for U.S. growth equities, underpinned by a belief for AI earnings and capital expenditure (capex) to stay strong. Our macro outlook expects U.S. economic momentum to slow and inflation to be sticky, but we remain broadly constructive on U.S. equities and favor a selective and nimble approach as macro data potentially softens.

International Equities

• International equities have led the way in gains this year and U.S. investors, who have tended to be under-allocated, are turning to the asset class to help build a well-diversified portfolio. A declining U.S. dollar has helped boost returns, potentially indicating a structural relationship change that requires investors to evolve portfolio construction.

Portfolio Insights

The foundational relationships that once anchored traditional portfolio construction have shifted – making many portfolios riskier overall. At the heart of asset allocation decisions lies the textbook relationship that stocks and bonds have had a negative correlation: when stocks go down as company prospects deteriorate, investors may turn to bonds in search of safer assets. This has remained the core underpinning of many portfolios’ most basic asset allocation breakdown.

But we believe this relationship has fundamentally shifted; less reliable correlations undermine the diversification benefits the two core asset classes provided each other. Unlike previous episodes of temporary correlation spikes, we believe today’s alignment between stocks and bonds, as shown in Figure 1, reflects deeper structural forces: persistent inflation dynamics, policy action and fiscal imbalances. This all suggests this regime may endure and fundamentally alter portfolio risk profiles (Figure 2).

Other, subtler, relationships appear to be shifting as well, further heightening the potential for risk. U.S. investors have long benefited from an overweight to domestic equities, but with an increased risk premium on the U.S. dollar, portfolios may benefit from exposure to international equities and digital assets. Within equity sleeves, the rise of AI has also meant a rise in U.S. index concentration, creating a need to source diversification elsewhere.² Falling rates and sticky inflation have created a challenge for investors seeking income, prompting us to consider short-dated TIPS and equity income as inflation conscious sources of cash flows. And within fixed income allocations, we feel how a portfolio sources duration is as important as how much there is overall, arguing for more active yield curve management than traditional benchmarks can offer.

Figure 1. Positive stock/bond correlation has been persistent

Figure 2. Equity and fixed income risks have moved structurally higher

We’ve already seen investors start to shift their portfolios amid this new regime and we expect this to continue. While capital flows pre-COVID closely resembled a 70/30 mix between stocks and bonds, we’ve seen an acceleration of investors diversifying their allocations. Client polling data shows that about half of our clients are looking to find diversification through alternatives such as liquid alternatives, commodities, and digital assets. Sentiment has remained robust despite ongoing macroeconomic and geopolitical uncertainty.³ Flows have favored exposures that offer uncorrelated returns and diversification.

Figure 3. Alternative and commodity flows take up a larger chunk of the pie

As investors rethink their portfolio allocations, we believe there is room to carve out space for non-traditional approaches and exposures. We feel a mix of liquid alternatives, digital assets, income strategies and international equities can help improve portfolio diversification. Our polling data suggests the intent is there: liquid alternatives were the top asset class clients selected as a portfolio diversifier.⁴ Strategic allocations to diversifying alternatives alongside traditional stocks and bonds can potentially result in improved risk-adjusted portfolio returns. We favor liquid alternatives that have a proven record of generating alpha relative to cash with low correlations to stocks and bonds (Figure 4).

Similarly, investors have allocated rapidly to digital currencies since the launch of physically backed ETPs in the space. There’s often a question of what role bitcoin should play in portfolios given its volatility and unique characteristics. With its elevated volatility, we believe bitcoin should be considered a “risky” asset on a standalone basis. However, most of the risk and potential return drivers bitcoin faces are fundamentally different from traditional risky assets, underscoring bitcoin’s intriguing potential as a unique contributor to portfolio diversification.

Although investors face new portfolio challenges in this new regime, we believe they can also benefit from an array of potential strategies.

View as of Aug. 25, 2025 from the Investment and Portfolio Solutions team and are subject to change.

Figure 4. Liquid alternatives have provided key sources of diversification and uncorrelated alpha

Figure 5. Look towards differentiated exposures

The iShares Bitcoin Trust ETF is not an investment company registered under the Investment Company Act of 1940, and therefore is not subject to the same regulatory requirements as mutual funds or ETFs registered under the Investment Company Act of 1940. The Trust is not a commodity pool for purposes of the Commodity Exchange Act. Before making an investment decision, you should carefully consider the risk factors and other information included in the prospectus

Fixed Income

Fixed income investors should consider a focus on harnessing income and yield opportunities while limiting their duration to the front end and belly of the curve. Inflation has moderated and the U.S. labor market has remained stable albeit slowing from 2024 levels.⁵ “We have a situation where we have two-sided risk, and that means there’s no risk-free path” Fed Reserve Chair Jay Powell said in his press conference on Sept. 17th when the FOMC announced it had cut overnight interest rates by 25 basis points.⁶

We anticipate the Fed will continue its easing cycle with potential additional overnight rate cuts by the end of the year. Until there is more certainty on the passthrough of tariffs to consumer prices and the composition of the FOMC, [among other issues,] we believe that the market may test the Fed’s resolve to ease by pricing firmer rates on the long end of the yield curve and wider inflation expectations. Households held nearly $20 trillion in cash and other liquid assets in the first half of the year, and they’ve allocated more to cash than to stocks or bonds over the last three years.⁷ As front end rates move lower, we believe investors should seek income elsewhere.

As correlations diverge rapidly, investors have changed where they source duration and diversification. Given the current correlation backdrop, as shown in Figure 6, we maintain our preference for the 3- to 7-year ‘belly.’ In our opinion, this rapid divergence also necessitates a more active oversight, even of core index holdings. ETF flows suggest that investors are abandoning the long end of fixed income markets; since November 2024, there have been over $5.6 billion in outflows from longer-term US Treasury ETFs vs. $68 billion of inflows into short-term US Treasury ETFs.⁸ Our team’s proprietary survey analysis also suggests that appetite for duration is dampening. In an August poll, just 12% of our clients said they were planning on adding US Treasuries in the next 3 months, down from 21% in June.⁹

Figure 6. Evolving correlation between U.S. Treasuries and equities

Looking forward, we continue to believe the ‘belly’ may outperform the long end. The continued normalization of term premia and concerns over the longer-term fiscal profile of the U.S. have added to the negative outlook for longer-duration bonds. By contrast, the ‘belly’ is one of the steepest parts of the yield curve and with our focus on income and carry, we believe that the allure of returns from rolldown only improves the risk/return of the 3- to 7-year sector. We see this sector of the curve as offering a mix of downside insulation while also participating in the benefits of modest duration especially at a time when the Fed is easing. Inflation expectations have remained elevated¹⁰ and we prefer shorter dated inflation linked bonds to seek to capture upside inflation risk in the near term via exposure to real rates.

We believe corporate credit investors should focus on income and carry rather than expecting significant spread tightening. Credit spreads look tight, but all-in yields have remained attractive, thanks to elevated risk-free rates. We favor selectively moving down in credit quality to seek more carry. In investment grade, we see lower-rated BBB bonds maintaining their solid credit metrics. By contrast, we think some caution is warranted for riskier high yield cohorts like CCC-rated bonds, which tend to require greater confidence in economic growth. Additionally, we feel short-term corporates currently offer greater portfolio-level diversification benefits to equities than longer-term Treasuries. The diversification edge of short-term credit over longer-duration Treasury bonds has been the strongest since the late-2017 to 2018 period of economic growth concerns.¹¹ Despite resuming the easing cycle in September, we believe the Fed will likely keep interest rates above neutral for longer. We see this providing an opportunity for investors to use active management strategies to seek to harness yield from high quality borrowers across diversified sectors in the fixed income markets.

International government bonds may offer an attractive alternative for U.S. investors. A portfolio of hedged, local-currency bonds from lower-coupon countries has often offered superior returns versus higher-yielding US Treasuries – thanks to the contribution that the currency hedge can make to total return.¹² So even while 10-year government bonds issued by Germany, France and Italy may have lower yields in EUR terms, when that is swapped back into U.S. dollars, the realized yields have been higher than the yield on a US 10-year Treasury.¹³ Given the integration of global credit markets and similar structural issues confronting the outlook for both U.S. and European rate investors, we also prefer the 3- to 7-year portion of global bond yield curves.

Figure 7. Comparative 10-Year government bond yields on a currency-hedged basis

U.S. Equities

Our view supports leaning into U.S. growth equities, underpinned by a belief for AI earnings and capex to stay strong. Our macro outlook expects U.S. economic momentum to slow but remain positive. While we remain constructive on U.S. equities, we favor a selective and nimble approach as macro data potentially soften.

Two questions have dominated discussions with allocators in recent months:

1. Are equity market returns going to broaden out?
2. How do you justify expensive valuations?

We see these questions as two sides of the same coin. Our belief is that market concentration has been the result of superior growth from a small set of tech and AI leaders. This dynamic has pulled the major U.S. equity benchmarks higher, as outsized returns from a handful of companies have carried index-level performance. In effect, the strength of these high-growth firms has not only driven concentration but also elevated the aggregate valuations of broad U.S. indices. We don’t see that trend reversing in the near-term.

Figure 8. Earnings growth is concentrated at the top

Equity market leadership:

We continue to prefer U.S. growth equities over value, based on an exceptionally strong fundamental outlook for U.S. tech companies benefitting from the ongoing AI capex wave.¹⁴ For the first time since the “Magnificent 7” term took hold, the cohort of mega-cap tech stocks underperformed broad U.S. equities in H1. But the Mag 7's 19% year-to-date return masks a 40% spread between top and bottom performers, potentially pointing to a new phase in the AI trade: market leadership is splintering, even at the top, as investors question legacy business models.¹⁵

We believe this fractured leadership justifies an active approach to AI. Calls for an end or plateau to AI capex growth have been persistent, but we believe there is still plenty of room for spending.¹⁶ McKinsey estimates that by 2030, $5.2T will be invested in AI datacenters across chips/hardware, power and land.¹⁷ Estimates indicate roughly $320B was spent on AI datacenters in 2023 and 2024 combined.¹⁸

Equity market leadership necessitates a more granular and tactical approach to factor investing. Quality has been little rewarded this year, with the factor trailing S&P 500 by 3%, but the reality is more nuanced.¹⁹ Balance sheet–oriented signals – such as low leverage and strong interest coverage have held up, while income statement factors like profitability and cash flow have lagged due to the rally in speculative, unprofitable high-beta names.²⁰ We still like quality at this stage in the economic cycle, but this year’s rapidly shifting sentiment and positioning indicators leave us with a preference for strategies that can actively rotate style exposure. As recent analysis from BlackRock Investment Institute (BII) shows, unmanaged factor exposures have become a significant drag on returns. This makes deliberate style factor management more important than ever.

Figure 9. Greater alpha potential

From a sector expression, financials remain our highest-conviction example of where broadening out has taken shape. U.S. financials, particularly banks, have benefitted from regulatory tailwinds, sticky inflation and a backlog of investment banking activity: all themes reinforced by Q2 earnings commentary. While tech and communication services have continued to lead in beats and forward guidance, and we believe AI will continue to be the growth engine of U.S. equity markets, we also like tactically expressing a preference to select sectors where fundamentals have remained robust.

Valuation concerns:

History shows that valuations have not been strong predictors of near-term performance. The market continues to clear all-time highs and currently trades at a 14% premium to its 5-year average forward Price to Earnings (P/E) ratio.²¹ However, since 2000, the correlation between the S&P 500’s forward P/E and its subsequent 6-month return has been -0.21. While the negative sign may suggest higher valuations have tended to precede lower returns, the relationship is weak – explaining less than 5% of the variation in short-term outcomes.²²

Further, while valuations may be high relative to historical averages, year-to-date returns for Tech and growth companies appear to come from earnings growth - not multiple expansion. Valuations have been responsible for fewer than 4% of returns for these cohorts, as shown in Figure 10.

Figure 10. U.S. tech returns have been driven primarily by earnings

While we don’t prefer using rich valuations as a sell signal, we also caution against using cheap ones as an indicator to buy. U.S. small caps currently trade at a discount versus historical averages.²³ But even as the Federal Reserve eases policy rates, we maintain our caution to small caps. We believe the exposure faces twin headwinds: historically greater sensitivity to economic growth, and fundamentals that have remained soft, with net margins not expected to return to pre-pandemic highs until 2026.²⁴

Importantly, we believe that as long as valuations remain supported by superior earnings growth, the market can potentially sustain these levels. Our takeaways from Q2 earnings reinforce that strength: it was one of the strongest seasons for earnings beats on record, and equally encouraging, Nearly 60% of companies raised full-year EPS guidance, double the pace seen in Q1.²⁵

International Equities

International equities have led the way in gains this year, although many U.S. investors may have missed these higher returns. Home country bias may be costing investors: The average advisor allocates 77.5% of their equity portfolio to the U.S., up from 70% in 2018.²⁶ Heightened international returns have followed a supportive mix of fiscal and monetary spending abroad, a weaker dollar, and the possibility of interest rate reductions in the U.S. International equities can help build a well-diversified portfolio, particularly as they show potential for continued support from potential dollar weakness.

Investors have started to correct for this underweight and turning to international, with non-U.S. equity exposures comprising 27.94% of total equity ETF flow YTD vs. 12% last year.²⁷ Across recent webinars we hosted, clients indicated that they are four times more likely to add exposure to European or developed international equities than to reduce it.²⁸ This builds on the trend observed of strong appetite for non-U.S. exposure. We believe there are three reasons why.

1 – Declining dollar has historically lifted international returns

We believe we are toward the beginning of a weaker dollar cycle, which has tended to boost international returns – potentially indicating a structural relationship change that requires investors to consider evolving portfolio construction. The dollar has long benefitted from a cycle of robust U.S. growth and investment. But we think the structural bull market may be challenged amid current trade policy, a reorientation of global growth and demand for alternative reserve currencies.

Historical evidence underpins our view that FX moves in sustained, longer-term cycles: since the end of Bretton Woods in 1971, we’ve observed six completed dollar cycles, with an average duration of about eight years (Figure 11). If we are at the beginning of a longer-term dollar cycle, we see reason to reconfigure portfolios. Unhedged international equities may stand to benefit the most from ongoing currency weakness.

Figure 11. We’re still early in the FX cycle

2 – Diversification amid U.S. concentration risks

International equities have proven to be better diversifiers to U.S. large caps than the small cap overweight most advisors hold. That relationship has been emphasized in drawdown periods: since 2010, when the S&P 500 posted negative quarterly returns, small caps underperformed significantly — posting nearly double the losses of developed markets.²⁹

Figure 12. International equities have shown to be a strong source of portfolio diversification

3 – Differentiate with selectivity and active management

Build a diversified international portfolio that seeks structural and cyclical opportunities by tapping into country level macroeconomic insights, thematic trends and systematic signals. We feel single country exposure like Japan represents a compelling tactical opportunity, underpinned by accelerating wage growth, meaningful corporate governance improvements and a favorable currency backdrop.³⁰ In Europe, structural themes and regulatory easing have supported the financials and aerospace and defense sectors. We feel recent earnings strength in European financials could continue with a steeper yield curve and regional economic resilience.³¹ Active management can help investors seek to make the most of this opportunity. An aggregate screen of company fundamentals, market sentiment, and macro themes can help drive discretionary decisions for stock level opportunities across different regions.

International factor exposures have historically lagged in adoption compared to the U.S. equity market.³² For portfolio construction, the diversification benefits via international factor tools have been notable. For example, Quality’s excess return correlation between domestic and international exposures is the lowest of any factor pair (0.33 for the last 10 years).³³ Meanwhile, international value has been a notable outperformer compared to the U.S. value factor, with companies abroad achieving higher dividend yields and earnings yields.³⁴ Tactically rotating within a set of rewarded factors based on forward-looking insights can help seek differentiated sources of diversification and potential returns abroad.