When we first opened Dunn Capital’s latest paper on trend following, we’ll admit we braced ourselves for another round of the usual talking points. You know the ones: “negative correlation,” “crisis alpha,” “diversification benefits”—all true, but frankly, we’ve heard it all before. The trend following community has been singing from the same hymnal for decades, and honestly, it was getting a bit tiring.

But then we got to the high volatility argument, and suddenly we were paying attention. This wasn’t just another rehash of why trend following works—this was something genuinely different, and frankly, something that doesn’t get nearly enough attention in the industry.

All Volatility isn’t BAD Volatility 

Most investors have been taught that volatility is bad, and that volatility equals risk. That can be true in many scenarios, but in the immortal words of just-retired Lee Corso: “Not so fast, my friends.”

We’ve been railing against this for years—the Sharpe ratio isn’t all it’s talked up to be because it treats ALL volatility (upside and downside) as risky. But is a large upside return really a bad thing? If a trend follower puts out a +70% year during a market crisis, is that risky? The Sharpe ratio says yes, penalizing strategies for exactly the kind of outlier positive performance that investors desperately need during crises.  It’s like evaluating a fire department based on how smoothly they drive to the station rather than how effectively they fight fires.

As we pointed out back in 2011, this is why the Sortino ratio makes more sense for alternatives—it only penalizes downside volatility. When you’re evaluating trend following or other momentum strategies designed to “let profits run,” punishing them for large positive returns because those returns increase overall volatility makes no sense whatsoever.

This flawed thinking connects perfectly with some arithmetic that we laid out years ago in our piece on allocation percentages that most investors still don’t understand. If you want a 5% allocation to alternatives to help you hit a 10% portfolio return target (assuming stocks and bonds return 6.5%), you need that alternative to return 76.5% annually. Yes, you read that right—76.5%.

That’s the brutal reality of small allocations. Most “smooth” alternatives targeting 8% returns aren’t moving the needle at all. We’ve been optimizing for comfort while achieving irrelevance, then using metrics that penalize strategies for delivering exactly what we actually need.

But here’s the real insight: a 15% allocation to a high-vol strategy targeting 40-80% returns during crises provides more protection than a 30% allocation to a low-vol alternative targeting 10-15% returns. You get better crisis protection and free up 15% of your portfolio for other opportunities.

Volatility Isn’t Risk When It’s Working For You

The advantages compound beyond crisis periods:

Rebalancing Bonus: Higher volatility creates more frequent rebalancing opportunities. When your high-vol alternative swings dramatically while equities remain stable, systematic rebalancing forces you to “sell high” and “buy low.”

Convexity in Extreme Scenarios: High-vol strategies perform disproportionately better in tail events rather than just moderately better in normal downturns—exactly when you need exponential protection. This is the kind of convexity that the Sharpe ratio penalizes but the Sortino ratio properly rewards.

Reduced Style Drift: Lower volatility alternatives often achieve smoothness by gradually shifting toward equity-like exposures when volatility spikes. High-vol strategies maintain their alternative characteristics when you need them most.

Better Risk-Adjusted Returns (When Measured Correctly): When you use metrics that only penalize downside volatility, high-vol trend following often shows superior risk-adjusted performance compared to its smoother counterparts.

More Bang for Your Buck: With most alternative strategies charging similar management and performance fees regardless of their volatility profile, high-vol strategies often deliver significantly better return per dollar of fees paid. If you’re paying 1.5% management and 15% performance fees, getting 40% returns during a crisis versus 10% returns means dramatically higher net returns for the same fee structure.

A Quick History Lesson:

Dunn’s piece gives a quick history lesson, talking about how back in the 1980s and early 1990s, most trend followers actually did target higher volatility. It was the growth of institutional allocation that changed the landscape.

The story goes like this: as large institutional investors started allocating to trend following in the 1990s, many requested lower volatility programs. The reasoning was understandable—they wanted to avoid difficult conversations with their boards during inevitable drawdown periods, even if those drawdowns occurred when their equity portfolios were performing well and they didn’t actually need help from their alternatives.

This created natural market pressure toward what institutions were asking for: smoother, more palatable return streams. The industry responded, with many managers developing lower-volatility products designed to meet this demand. It’s a perfectly rational market response, but it may have come at the cost of crisis protection effectiveness.

The Bottom Line:

As we once put it: “The simple truth is that the smaller your allocation to alternatives is, the larger the alternatives return has to be to move the overall needle.”

Dunn’s high-volatility argument isn’t just about trend following—it’s about fundamentally rethinking our relationship with volatility itself and the metrics we use to evaluate it. We’ve been taught that volatility equals risk, but that’s only true when volatility is working against you. When it’s uncorrelated to your other holdings, shows up during equity crises, and delivers explosive upside when you need it most, volatility becomes your best friend.

The question isn’t whether you’re comfortable with higher volatility in your alternative allocation. The question is whether you can afford to build a portfolio without strategies designed to be volatile in service of protection when traditional diversification breaks down.

Sometimes the position that feels less comfortable in isolation, gets penalized by traditional risk metrics, and challenges conventional wisdom is exactly what makes the most sense for the portfolio as a whole. Coach Corso had it right—when everyone’s running one way based on flawed conventional wisdom, it might be time to pump the brakes and think differently.

 

📄 Read the full paper from Dunn Capital: High-Vol Trend Following – The Most Valuable Alternative Investment? 

 

Listen/Watch our episode of The Derivative with Marty Bergin here