Real Diversification Feels Wrong... Until It Saves You

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Most investors say they want diversification. Few actually own it.

Spend a moment looking at the so-called “alternative investments” that fill institutional and individual portfolios. You see private equity, hedge funds, real estate, and other strategies that feel unconventional and even exotic. They may carry high fees, opaque structures, and the sense of exclusivity that makes investors feel they own something special. Yet when markets stumble, these assets usually stumble too. They may dress differently, but when the tide goes out, their returns are still tied to the same forces that drive equities.

The illusion is subtle but costly. When stocks surge, private equity and hedge funds ride the wave. When stocks sink, those same “alternatives” often slide alongside them. Perhaps the fall is not as steep, but it is still painful. During the 2008 financial crisis, hedge funds lost nearly a quarter of their value, while the S&P 500 fell by half. The gap mattered, but the result was still devastation for investors who believed they had built a lifeboat. The reality was that they had constructed something closer to a slightly sturdier ship, still sailing in the same storm.

A true alternative should not be defined by its fees, its legal wrapper, or its complexity. It should be defined by the timing of its returns. It should zig when equities zag. It should thrive when fear spreads. Above all, it should provide ballast during equity bear markets, when liquidity and confidence are most scarce and when investors face obligations they cannot postpone.

That is what high-volatility trend following has repeatedly delivered.

What Makes a Real Hedge

The purpose of alternatives is not necessarily to beat equities. It’s to complement them. Investors rarely think in terms of infinite horizons. They live in real time, needing to fund pensions, meet redemptions, or take withdrawals for living expenses. The challenge is that these obligations arrive on schedules that cannot be controlled. A strategy that compounds nicely over fifty years but collapses alongside equities in the wrong two-year window does not offer meaningful help.

The value of trend following lies in its different rhythm. It does not rely on earnings, GDP growth, or central bank policy. It follows prices and adapts to direction rather than predicting it. That makes it one of the few strategies that can consistently move on a schedule distinct from equities.

Furthermore, the return profile of high-volatility trend-following strategies exhibits features that are most crucial during periods of crisis. Its correlation with equities is low or negative. Its distribution of returns is positively skewed, meaning that outlier events tend to skew the distribution toward gains rather than losses. And it is convex, tending to deliver larger profits when market moves are larger, the exact opposite of equities that usually bleed most when volatility spikes. These qualities together make the strategy not just different, but genuinely diversifying.

History as Proof

Over the past quarter-century, the evidence has been clear. When the dot-com bubble burst between 2000 and 2002, the S&P 500 fell almost 45 percent. High-volatility trend following more than doubled. During the global financial crisis from 2007 to 2009, the value of equities was cut in half. High-vol trend gained about 40 percent. In the inflation-driven selloff of 2022, the S&P dropped a quarter while high-volatility trend rose nearly 80 percent. Even during the short, sharp Covid crash of 2020, when the S&P lost about 20 percent in a matter of weeks, trend following held flat to slightly positive.

These are examples of a strategy delivering exactly what investors hope to see from diversification but rarely do. In each of these moments, when liquidity was scarce and fear was pervasive, trend following provided ballast. It turned the concept of “hedge” from marketing language into lived reality.

The Portfolio Effect

Judged on its own, trend following does not always look impressive. Over long periods, its Sharpe ratio lags behind other alternative strategies. But portfolios are not built from isolated Sharpe ratios. They are built from interactions.

Consider the classic 60/40 portfolio. Alone, it produces attractive long-term returns but carries vulnerability during equity dislocations. Add high-volatility trend following as a twenty percent sleeve and rebalance annually. Over the past twenty-five years, this combination would have improved Sharpe ratios, reduced drawdowns, and smoothed the overall path of returns. During 2008, the difference was stark. The plain 60/40 portfolio lost more than 30 percent. The version with high-volatility trend lost less than half that amount.

This is the essence of diversification: not necessarily higher returns, but better outcomes when returns are needed most. Investors often speak about compounding, but compounding is fragile. It depends on survival. Reducing drawdowns, even if it means tolerating duller performance in calm times, allows compounding to continue. That’s the hidden strength of high-volatility trend following.

Why High Volatility Matters

A natural question arises. If trend following is so effective, why have more managers not embraced higher volatility programs? The answer lies less within the strategy and more in human psychology.

As institutional money flowed into CTAs in the 1990s, large pensions and endowments began to dictate the terms. They wanted the strategy, but not its swings. They demanded lower volatility so they would not have to explain uncomfortable drawdowns to boards and committees. Managers responded by creating low-volatility versions. These funds still offered diversification, but the effect was muted. They gathered assets and charged fees, but they did not deliver the full power of crisis protection.

This was a trade-off, and not one that favored investors. The paradox is that in order to avoid scrutiny in the easy times, institutions gave up protection in the hard times. The high-volatility programs may look uncomfortable when equities are calm, but they shine when markets are in turmoil. They offer more efficient use of capital, requiring smaller allocations to achieve meaningful portfolio protection. In the real world, that means a portfolio might be down three percent during a bear market instead of twenty-five percent. That gap is not academic but rather the difference between clients holding steady or demanding change.

Lessons for Investors

The lesson is that complexity is not the same as diversification. Many alternatives wear exotic labels but ultimately deliver the same equity exposure in disguise. What matters is not how a strategy looks on the surface, but when and how it delivers returns.

The timing of returns is the most underappreciated dimension in investing. An asset that pays when others suffer is more valuable than one that shines in bull markets. Trend following offers exactly that, especially in its high-volatility form.

Owning such a strategy can be uncomfortable. In placid times, it may seem like a laggard. Its volatility may draw attention when steady gains are the norm. Yet it is precisely that discomfort that makes it valuable. True diversification never looks like what you already own. It feels strange, sometimes even ugly, until the moment you need it.

In many ways, investing is a game of survival and endurance. To survive, you need protection against the periods that break others. To endure, you need to smooth the path enough to stay invested. High-volatility trend following delivers both. It’s not about owning more, but about owning something different.

True diversification is scarce. For those who understand it and commit to it, high-volatility trend following may be the most different and therefore the most valuable alternative investment available today.

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True diversification is not just a theory but a measurable edge. The latest research at DUNN Capital, the firm I work with, reveals which alternative strategies actually deliver protection when it matters most. To see the full analysis and understand what it means for your equity and bond allocations, download your free copy now. 

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