Alts: Volatility Is Not Your Enemy

If returns are uncorrelated and positive.

April 2026. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

• The less correlated an alternative strategy is, the higher its volatility should be
• Enables more efficient capital allocation
• However, only if the returns are positive

INTRODUCTION

Prior to 2000, the hedge fund industry managed less than $500 billion in assets, and most funds reported performance quarterly or annually. Much like private equity, this infrequent reporting had a smoothing effect on returns – the intra-month and intra-quarter swings that inevitably occurred were simply never visible to investors.

Today, with the industry managing close to $5 trillion, monthly reporting has become the norm, and many funds – particularly European UCITS vehicles and ETFs – publish daily returns. Greater transparency is welcome, but it has come at a cost: investors are now fully exposed to the day-to-day rhythm of markets, and high volatility has become something of a negative attribute. Multi-strategy hedge funds like Millennium, which diversify across strategies and run sophisticated risk management systems specifically designed to dampen volatility, have risen to dominate the industry as a result.

But should investors actually treat volatility as a flaw in an alternative investment strategy?

In this article, we argue that it is not the enemy.

VOLATILITY VS CORRELATIONS

Throughout this article, we will use gold as a proxy for an uncorrelated strategy. Between 2007 and 2026, gold’s average correlation to the S&P 500 was just 0.1 – but that figure masks considerable variation. At its most diversifying, the correlation fell to -0.6 in 2015; at its least, it rose to 0.6 in 2012. The diversification benefit, in other words, was far from constant.

Source: Finominal

The shifting correlation between gold and equities is mirrored in their volatility profiles. Over the same period, the S&P 500 averaged annualized volatility of 15.4%, modestly below gold’s 17.2% – a reminder that gold is not inherently a low-volatility asset. Both series exhibit substantial dispersion around those averages, with volatility spiking sharply during periods of market stress, most notably during the Global Financial Crisis in 2008.

Source: Finominal

GOLD SCENARIOS

To isolate the effect of correlation, we constructed synthetic variants of gold that preserve the same 17.2% annualized volatility and identical total return over the period, but with correlations to the S&P 500 ranging from +0.75 down to -1.0. Everything else held constant, only the correlation changes.

Source: Finominal

QUANTIFYING DIVERSIFICATION BENEFITS

We then simulate adding a 20% allocation to gold – rebalanced annually – to an otherwise pure S&P 500 portfolio. The result: the Sharpe ratio improves from 0.67 to 0.85 over the 2007-2026 period. Running the same exercise across our synthetic gold variants reveals a near-linear relationship between correlation and the Sharpe ratio – the lower the correlation to equities, the greater the diversification benefit and the higher the resulting risk-adjusted return. The direction of the effect is unambiguous and as expected.

Source: Finominal

We then stick to the gold scenario with the 0.1 correlation to the S&P 500, and instead vary gold’s volatility, scaling it from its base level of 17.2% up to 34.3% – a doubling of annualized volatility. Rather than harming portfolio efficiency, the higher volatility actually improves it: the Sharpe ratio rises steadily from 0.85 to 0.92 as gold becomes more volatile. When correlation is low, volatility in the uncorrelated asset is not a drag – it is a diversifier.

Source: Finominal

The reverse holds equally true. Compressing gold’s volatility by 80% – from 17.2% to just 3.4% – causes the portfolio’s Sharpe ratio to fall from 0.85 to 0.73. The less volatile the uncorrelated asset, the less work it does.

Source: Finominal

ATTRACTIVE VS UNATTRACTIVE UNCORRELATED RETURNS

Our analysis so far shows that higher volatility is not inherently a negative feature for uncorrelated investments – in fact, it adds value as correlation becomes more negative. But this conclusion rests on a key assumption: that the uncorrelated asset actually delivers a meaningful return. Gold, in our case study, earned a CAGR of 10.9% between 2007 and 2026, modestly ahead of the S&P 500’s 10.4% – a favourable backdrop that few if any alternatives can claim.

When we replace gold’s return history with a flat 0% total return – keeping the 0.1 correlation intact – the picture changes entirely. Higher volatility now works against the portfolio, and the Sharpe ratio declines steadily as volatility increases. The implication is clear: volatility is only an ally when the underlying strategy is generating positive returns. Without that foundation, it simply amplifies noise.

Source: Finominal

FURTHER THOUGHTS

One practical advantage of high-volatility, uncorrelated strategies is capital efficiency: because their diversification punch is stronger, smaller allocations are needed to move the needle. Multi-strategy hedge funds with suppressed volatility suffer the opposite problem – they demand large allocations to deliver meaningful portfolio-level benefits.

The drawback is behavioural. Investors are rarely indifferent to large drawdowns on their statements, even when those losses are entirely rational in a portfolio context. This tension goes a long way toward explaining the dominance of large multi-strategy funds, which are acutely aware of and exploit the behavioural biases of both allocators and market participants.

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ABOUT THE AUTHOR

Nicolas Rabener is the CEO & Founder of Finominal, which empowers professional investors with data, technology, and research insights to improve their investment outcomes. Previously he created Jackdaw Capital, an award-winning quantitative hedge fund. Before that Nicolas worked at GIC and Citigroup in London and New York. Nicolas holds a Master of Finance from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (Ironman & 100km Ultramarathon).

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