Portfolio diversification aims to reduce the risk of investing in any particular asset. Trend-following aims to profit from outlier trades.
If a trend-follower knew beforehand which markets would generate outliers, they would also know what to only trade. Since knowledge of the future is impossible, trend followers are forced to “diversify” across a large number of markets in the hope of catching outliers. In this case, diversification has the adverse effect of limiting potential gains from outliers.
In its traditional meaning, diversification is used to spread the risk across different asset classes in a strategic sense. The portfolio manager may rebalance the portfolio at regular intervals. In tactical investing, the portfolio may be rebalanced using timing methods and volatility considerations. In both cases, the objective is to limit exposure to individual asset classes.
In trend-following, “diversification”, if any, is restricted to the spreading of risk across the signals that occur in time. As a result, at any particular moment, the portfolio may be exposed only to a limited number of asset classes or even have a large exposure to only one. We observed the effects of a lack of diversification in the CTA space during the regional bank crisis with a 9-sigma event. Many CTAs, and some replicators, were heavily short fixed-income futures, and the rally in bonds caused significant losses.
With trend-following, due to trading many different markets, diversification is dynamic and may not be present when it is needed. Trend-followers are “forced” to diversify to hunt outlier trades. Since markets cannot guarantee the timing of these outliers, trend-following may not provide any diversification for extended periods, although theoretically at least, it is a diversified method of trading.
Despite these shortcomings, trend-following has the potential to offer convexity to equity market declines, but at the cost of extended periods of underperformance. In that sense, trend-following is a diversifier. However, trading in many markets and hunting for outliers is not diversification in the traditional sense.
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Disclaimer: No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.
Charting and backtesting program: Amibroker. Data provider: Norgate Data