For advisors who were trying to diversify stock-heavy portfolios, 2011 was a year for the record books. While some assets proved to be unusually powerful diversifiers, other investments provided little diversification at all. The unusual pattern can be attributed to so-called risk on-risk off trading. During periods when investors gained confidence, they bought all kinds of stocks and risky assets — only to sell when the news headlines became unnerving.

To appreciate how extreme the trading became, consider data on correlations. When assets move in lockstep, they have a correlation of 1.0, and when they move in precisely the opposite direction, the correlation is -1.0. Among the best diversifiers last year were Treasuries. Over the decades, Treasuries have often had a correlation of 0.2 with the S&P 500. But in 2011, the correlation was -0.8, the lowest figure in 13 years, according to Factor Advisors, a New York-based asset management firm. At the other end of the spectrum, oil — which often zigs when stocks zag — had a correlation with the S&P of more than 0.50 — in other words they were engaged in quite a bit more shadow play than usual.

Correlations have been trending upwards for much of the past decade, says David Darst, chief investment strategist for Morgan Stanley Smith Barney. During the period from 2002 to 2011, the MSCI Emerging Markets Asia index had an unusually high correlation of 0.87 with the S&P 500, while the NAREIT REIT index posted a figure of 0.84. “People think that they are getting diversification when they buy REITs or foreign stocks, but that hasn't been working,” says Darst.

For protection in downturns, investors should use the few asset classes that have low or negative correlations, says Darst. Besides government bonds, the good diversifiers include cash, gold, managed futures, and inflation-protected bonds. For his moderate-risk portfolios, Darst has been raising his allocation to the strong diversifiers, putting 7 percent in cash, 7 percent in managed futures, and 10 percent in government bonds. He only has 33 percent of assets in stocks.

Like Darst, other advisors and fund managers are taking a new look at diversification. They are putting a new emphasis on bonds and underweighting stocks that track the S&P 500. For its target-date retirement funds, Invesco has devised an unusually bold approach. The funds start with a neutral allocation that puts most assets in bonds along with a big stake in commodities. In 2011, the strategy produced noteworthy results. For the year, Invesco Balanced-Risk Retirement 2040 (TNDAX) returned 10.3 percent. In comparison, nearly all its peers lost money, and the average fund with a retirement date of 2036-2040 declined 3.5 percent, according to Morningstar.

The Invesco fund is one of a number that follow risk-parity strategies. Others include AQR Risk Parity (AQRIX) and Managers AMG FQ Global Essentials (MMAVX). These aim to serve as alternatives to traditional portfolios that have 60 percent of assets in equities and 40 percent in bonds. Proponents of risk-parity funds say that the weakness of the classic allocations became apparent in 2008 when a traditional portfolio would have lost 18 percent. During the downturn, the Barclays Capital Aggregate Bond Index returned about 8 percent, but the gains did little to protect investors in a year when the S&P 500 lost 37 percent. Risk-parity managers say that 60-40 portfolios did so badly because they rely too heavily on stocks. While the classic portfolios only have 60 percent of assets in equities, the equities account for 90 percent of the risk, as indicated by standard deviation.

To make sure that no one asset class swamps a portfolio, risk-parity funds balance their holdings so that each asset class accounts for an equal amount of the risk. The Invesco fund has a neutral allocation of 90 percent in government bonds, 30 percent in stocks, and 30 percent in commodities. The numbers add up to more than 100 because the fund uses futures, which can be leveraged. The approach has served the Invesco funds well in a variety of market conditions. “When stocks are struggling, we can have positive returns,” says Scott Wolle, portfolio manager of Invesco's risk-parity funds. “We will not have market-beating returns when the market is rising strongly, but we should be able to post some attractive results.”

Some funds have tried to cope with volatile markets by using dynamic asset allocation. This calls for varying allocations widely as market conditions change. Funds that range widely include Leuthold Core (LCORX) and Ivy Asset (WASAX). A solid performer is Sierra Core Retirement (SIRAX), which can hold up to 70 percent of assets in equities and risky assets such as high-yield bonds. In 2011, Sierra portfolio manager David Wright grew wary and began reducing his risky holdings. By the end of the year, he had gotten rid of nearly all his equities and high-yield bonds. The shift enabled the fund to finish in the top half of its category for the year while taking much less risk than most competitors.

Wright's goal is to outdo typical core bond funds while being only a bit more volatile. To implement the strategy, he buys mutual funds and ETFs, searching for managers with strong risk-adjusted returns. Wright follows trends, investing in assets that are rising. He grew wary of stocks last year as markets around the world began peaking and heading down. “There is not much upside to the U.S. stock market,” he says.

Folio Investing, an online broker, takes an unusual approach to diversifying target-date retirement funds. Typical target-date portfolios invest in broad funds that track the S&P 500 or the MSCI EAFE index of international stocks. But Folio argues that such holdings are too highly correlated. To get better diversification, Folio's funds hold collections of narrow sector funds. Consider Folio's Target 2030 Moderate portfolio, which holds Vanguard Energy (VDE) and Vanguard Information Technology (VGT). “If you just hold a domestic index fund and an international index fund, you don't have much diversification,” says Greg Vigrass, president of Folio Institutional.

While it is too soon to draw any firm conclusion about Folio's innovative approach, Vigrass says that the results during the past three years have been compelling. He says that the strategy is helping to lower volatility while delivering competitive returns.