A practitioner’s case for genuine diversification in a multi-strategy portfolio

Genuine diversification is a function of how many distinct economic forces drive a portfolio’s returns, not how many strategies or asset classes it contains. This is why a regime-insensitive strategy such as trend following can occupy a distinct role within a multi-strategy portfolio.

Portfolio construction in a multi-strategy context is often approached as a question of correlation between strategy returns. In principle, correlation should reveal where return drivers align. In practice, a shorter measurement window can mask this. Two strategies sharing an underlying driver can still show low correlation over that period, either because the driver has not moved, or because it shows up in each strategy with a different lag.

A return driver is the underlying economic force behind a strategy’s profit and loss. Equity long/short is tied to earnings, growth and rates. Credit strategies are tied to spread movement, default risk and liquidity. Event-driven strategies depend on specific corporate situations, though the risk appetite behind their pricing is sensitive to growth and rates. These may look like distinct strategies, yet beneath the surface many share a common set of macro drivers.

That overlap tends to be masked during calm periods, when strategy returns can appear independent. It becomes visible the moment a shared driver is disturbed: a sharp rise in inflation expectations, for instance, pushes rates higher, weighing on equity valuations, raising property borrowing costs, widening credit spreads and eroding bond values, often all at once. A multi-strategy portfolio that looks diversified on a correlation matrix can still carry concentrated exposure to a single macro shock.

Systematic trend following offers a genuinely distinct return driver. Rather than depending on economic growth, falling rates or rising prices, it seeks to identify and follow sustained directional price movements across futures markets. It requires no particular economic outcome to perform, which is the source of its regime insensitivity. It can participate in a rising equity market, a shift in bond yields, a commodity shock or a currency realignment: what matters is the presence of a trend, not its direction or the asset class involved.

That is why trend following tends to sit apart from the correlation cluster connecting most other strategies during periods of stress. It also carries a structural liquidity advantage: positions in single stocks, corporate credit or other less liquid instruments can become difficult to unwind exactly when a portfolio needs to reduce risk, while futures markets remain liquid and centrally cleared.

Trend following is often associated with providing “crisis alpha”, reflecting the style’s tendency to generate uncorrelated returns precisely when conventional portfolios are under the greatest strain. Sustained directional moves are common during market stress, since that is when investor behaviour turns most one-sided.

The pattern is not merely theoretical. During 2008, when equity and credit markets fell sharply, trend-following strategies as a group were widely documented to have delivered strong positive returns. That episode does not guarantee future performance, and trend following underperforms in range-bound or whipsaw conditions. It illustrates why the return driver, not the asset class, determines how a strategy behaves when a shared shock hits the portfolio.

The distinction extends to construction across strategies, not just asset classes. A 2018 paper by AIMA and the CAIA Association, “Portfolio Transformers: Examining the Role of Hedge Funds as Substitutes and Diversifiers in an Investor Portfolio”, grouped hedge fund strategies into substitutes and diversifiers. Substitutes, such as long/short equity and event-driven, tend to retain meaningful equity beta. Diversifiers, such as global macro and managed futures (trend following), show materially lower correlation to that same driver. A multi-strategy book weighted toward substitutes may carry more shared risk than its headline diversification suggests.

While classified as a diversifier, trend following is not a hedge that only pays off when markets fall. Should equities, credit or any other market rise steadily, a trend-following strategy would typically participate too, generating positive returns correlated with the trend. It is positioned with whatever is moving, not against any particular strategy or asset class.

Conviction in a given strategy or asset class tends to be strongest after a sustained run of favourable performance. That is usually also the point at which crowding risk is highest. Long-run allocation frameworks exist to guard against this tendency, though they cannot say when conditions will actually shift.

Trend following does not need to call that top. Its systematic rules let it participate in a crowded, even bubble-like, market for as long as the trend continues, while built-in risk controls let it reduce or exit that position once the trend reverses. It requires no forecast of when a bubble will burst, only a disciplined process for responding once it does.

For an allocator, the practical discipline is mapping correlation at the level of return drivers, not strategy labels. Two managers with different names may still share the same underlying force, while two with similar labels may not. Genuine diversification sits in that distinction.

No manager, however sophisticated, can consistently time that turn in advance, and none needs to. The case for trend following in a multi-strategy portfolio does not rest on a view about where markets go next. It rests on holding a return driver, the presence of a trend, that is structurally distinct from most other strategies. That driver tends to assert itself when those strategies are under strain, and it requires no particular economic outcome to do so. That is a genuine complement to the prevailing consensus, capable of generating returns regardless of how it resolves.

This article is prepared by ECCM Australia Pty Ltd (ACN 664 662 846), corporate authorised representative of East Coast Capital Management Pty Ltd (ACN 129 976 905, AFSL 339300). It is educational and general in nature and does not constitute financial product advice. Past performance is not indicative of future performance.
 

Trend following is often associated with providing “crisis alpha”, reflecting the style’s tendency to generate uncorrelated returns precisely when conventional portfolios are under the greatest strain. Sustained directional moves are common during market stress, since that is when investor behaviour turns most one-sided.