The Decline of Broad Diversification in a Postmodern Market Era

In the evolving landscape of global investing, the once-reliable pillars of diversification are showing cracks. For decades, investors relied on broad geographic and asset-class diversification to mitigate risk, assuming that uncorrelated markets would act as a buffer against volatility. However, recent trends suggest that the interconnectedness of global markets—once a driver of synchronized returns—is now giving way to a fragmented, low-correlation environment. This shift has profound implications for portfolio construction, particularly for those seeking outperformance in an era where traditional diversification strategies are losing their edge.

The Shifting Correlation Landscape

From 2020 to 2024, global equity markets became increasingly intertwined as companies expanded their international revenue streams. This globalization of business operations led to higher correlations between regional markets, reducing the diversification benefits of holding a globally diversified portfolio. However, 2025 marked a reversal. By May 2025, 31 out of 48 countries in Morningstar's study had shifted toward domestic revenue sources, with the U.S. market increasing its domestic revenue share from 60% to 61%. Similar trends were observed in Japan and Europe, signaling a retreat from globalization and a renewed focus on local economies.

This shift has two key implications. First, it reduces the correlations between equity markets, potentially enhancing diversification benefits—particularly for emerging markets, which have historically been less integrated. Second, it reshapes the role of multinational corporations in national indices. For example, U.S. tech giants like Microsoft and Apple now derive a larger portion of their revenue domestically, influencing the performance of the S&P 500. In contrast, emerging markets like India or Indonesia, where domestic revenue remains dominant, may see their equities become more closely tied to local economic conditions.

Active Stock Selection: The New Edge in Fragmented Markets

As correlations decline and returns become more fragmented, the role of active stock selection is gaining prominence. Passive strategies, which thrive in low-volatility, high-correlation environments, face diminishing returns when market movements are erratic and sector rotations accelerate. The 2023–2025 period exemplifies this challenge. During Q2 2025, geopolitical tensions and policy shifts—such as the announcement of reciprocal tariffs—triggered a 23% sell-off in the Nasdaq, followed by a 33% rebound. Active managers, constrained by concentrated portfolios and rigid style tilts, struggled to adapt. Only 38% of 1,500 global equity funds analyzed achieved positive relative returns year-to-date, while diversified, systematic strategies outperformed.

The key differentiator lies in the ability to navigate fragmented returns. In a low-correlation environment, where a broader range of stocks contribute to market performance, active managers with the skill to identify undervalued opportunities and avoid underperforming sectors can generate alpha. For instance, during the 2023 market correction, active strategies outperformed by adjusting exposure to defensive and value stocks, while passive strategies were forced to hold underperforming growth stocks. This flexibility is critical in markets where dispersion is high and returns are not driven by a narrow group of dominant firms.

The Case for Active Management in a Postmodern Era

Historical data underscores the cyclical nature of active versus passive performance. From 2000 to 2009, active strategies outperformed in nine out of ten years, while passive strategies dominated in the 1990s. Over the past 35 years, the two approaches have traded the lead, with active outperforming 17 times and passive 18 times. This suggests that the dominance of passive strategies is not permanent. As markets evolve into higher-dispersion environments, active management is poised to regain its edge.

The rise of index concentration further amplifies this dynamic. The "Magnificent 7" now account for over 32% of the S&P 500, making it difficult for active managers to differentiate their portfolios. However, in a fragmented market, where returns are spread across a broader range of stocks, active managers can exploit inefficiencies. For example, during the 2023 correction, active strategies that reduced exposure to overvalued tech stocks and increased positions in undervalued sectors outperformed their benchmarks.

Investment Advice for a Fragmented World

For investors, the declining efficacy of broad diversification necessitates a strategic shift. Here are three actionable steps:

1. Reallocate to Active Strategies in Less Efficient Markets: Active management has historically outperformed in U.S. small-cap, international developed, and emerging markets—sectors where inefficiencies are more prevalent. These markets offer greater opportunities for skilled stock selection.
2. Embrace Systematic, Diversified Approaches: In volatile environments, systematic strategies that avoid concentrated bets and adapt to shifting market conditions can provide superior risk-adjusted returns. For example, a quant-based portfolio with broad sector exposure can absorb style and sector reversals more effectively than discretionary active funds.
3. Monitor Geopolitical and Policy Risks: The 2025 tariff-driven volatility underscores the importance of agility. Investors should prioritize strategies that can quickly adjust to macroeconomic shifts, such as those incorporating real-time data analytics or dynamic hedging.

Conclusion

The postmodern market era is defined by lower correlations, fragmented returns, and rapid shifts in sector leadership. In this environment, traditional diversification strategies are no longer sufficient. Active stock selection, particularly in less efficient markets and during periods of high dispersion, is emerging as the defining edge for outperformance. By embracing active management and systematic approaches, investors can navigate the complexities of a fragmented market and position themselves for long-term success.