Investors are constantly seeking ways to diversify their portfolios to manage risk and improve returns. In an increasingly interconnected financial world, finding true diversification is challenging. Two strategies — Trend Following and Insurance-Linked Securities (ILS) —stand out not only for their low correlation with traditional assets but also for their ability to protect portfolios during periods of market stress. 

While many asset classes or investment strategies may seem diversified during calm market conditions, they often lose these benefits when it matters most—during market turmoil. Both Trend Following and ILS excel by offering diversification benefits that persist even when equity markets are in crisis. In this post, we’ll explore how these two strategies provide both uncorrelated returns and downside protection, making them indispensable tools for portfolio construction.

The Dual Power of Diversification: Correlation and Downside Protection

Traditional diversification focuses on correlation—the degree to which two assets move in relation to each other. By holding assets with low or negative correlations, investors can reduce the risk of their portfolios. However, there’s another critical dimension to diversification: downside protection, or how an asset behaves during market stress. 

In many cases, assets that appear uncorrelated during stable periods can become highly correlated during crises, offering little protection when it’s needed most. The true test of diversification lies not just in average correlation, but in an asset’s correlation to equities during market stress. This is where Trend Following and ILS provide significant value.

Trend Following: Profiting from Market Momentum

Trend Following strategies, typically implemented through managed futures or Commodity Trading Advisors (CTAs), are designed to capture market trends by going long in rising markets and short in falling ones. This momentum-based approach allows Trend Followers to thrive in both bull and bear markets.

What sets Trend Following apart from other strategies is its ability to perform well during periods of market dislocation. When equity markets are in turmoil, Trend Followers often take short positions, profiting from falling prices. Historically, this has resulted in negative correlations with equities during crises, making Trend Following a powerful tool for downside protection.

Correlation during market stress: During financial crises, such as the 2008 global financial crisis and the COVID-19 market crash, Trend Following strategies delivered strong returns, while traditional assets faltered. By capitalizing on sustained trends during these periods, Trend Followers have proven to be a valuable hedge against market downturns.

Insurance-Linked Securities (ILS): Unaffected by Financial Markets

Insurance-Linked Securities (ILS), particularly catastrophe bonds, provide another layer of diversification. Unlike Trend Following, which thrives on market trends, ILS returns are driven by non-financial risks such as natural disasters (e.g., hurricanes, earthquakes). As a result, ILS is largely independent of economic cycles, interest rates, or corporate earnings.

Because their performance is tied to insurance events rather than financial markets, ILS offers true uncorrelated returns that remain unaffected even during periods of severe market stress. This makes them particularly attractive for portfolios seeking diversification away from traditional asset classes like equities and bonds.

Correlation during market stress: During the 2008 financial crisis and other periods of market volatility, ILS exhibited no correlation to equities. Investors in ILS were able to avoid the drawdowns that plagued most financial assets, providing a unique form of downside protection that was immune to broader market turmoil.

Comparative Analysis: Diversification Across Two Dimensions

To better understand how Trend Following and ILS stack up against other asset classes and strategies, let’s compare them based on two key dimensions: average correlation and correlation to equities during market stress. These metrics provide a more nuanced view of diversification, considering both calm and turbulent periods. Our analysis is based on the period between 2008 – 2024.

Crisis Alpha: How Trend Following and ILS Protect During Market Turmoil

What makes Trend Following and ILS stand out is their ability to generate crisis alpha—positive returns during periods of market stress.

Trend Following: Historically, Trend Following strategies have performed well during major market crises. For example, during the 2008 financial crisis, Trend Followers were able to profit from sustained downward trends in equities, commodities, and other markets. Similarly, during the COVID-19 market crash in early 2020, Trend Followers took advantage of sharp price movements, delivering positive returns while equities tumbled.

Insurance-Linked Securities: ILS’s independence from financial market risk means that its returns remain stable during market downturns. In the 2008 financial crisis, for instance, ILS returns were unaffected by the broader market collapse, providing a reliable source of returns when most other assets were struggling. Since ILS returns are driven by non-financial events like natural disasters, they provide investors with diversification that is not correlated with economic downturns or financial crises.

Why Investors Need Both Correlation and Downside Diversification

Many portfolios are built around the idea of correlation-based diversification, but this alone may not be sufficient to protect against severe market downturns. As we have seen in multiple financial crises, assets that appeared uncorrelated during stable periods can become highly correlated in moments of stress, offering little downside protection.

This is why both correlation and downside diversification are essential. Trend Following and ILS excel in both areas. They not only provide low or negative correlations with equities in average market conditions, but they also deliver significant downside protection when equity markets are under severe pressure. By incorporating these strategies into a portfolio, investors can benefit from both the long-term diversification of uncorrelated returns and the crisis protection needed during market turmoil.

Conclusion: The Best of Both Worlds

In a world where traditional asset classes and many hedge fund strategies become correlated during market stress, Trend Following and Insurance-Linked Securities (ILS) stand out as two strategies that offer true diversification—both in calm markets and during crises. 

• Trend Following captures momentum, performing well during prolonged trends, and is often negatively correlated with equities during market downturns.
• ILS remains unaffected by financial market fluctuations, providing a source of returns that is truly independent of economic or market conditions.
  
  

Together, these strategies offer not just uncorrelated returns in normal market environments but also downside protection during periods of market stress. By incorporating both Trend Following and ILS into their portfolios, investors can achieve a more resilient portfolio, capable of weathering financial storms and capturing non-traditional sources of return.