Managed futures diversification - the strategy dimension matters

All managed futures managers diversify. In fact, I would venture that there is more cross-asset diversification in managed futures than any other hedge fund strategy. The diversification is across commodities, fixed income, rates, foreign exchange, and stock indices. It is the key to their success and survival.  The premise is to find as many unique market opportunities as possible. This is only possible through examining and trading a broad set of markets across all market sectors.

However. the diversification discussion usually focuses only on the number of markets traded. In reality, the diversification dimension that may be more important for a manager's success and survival is strategy.   It is strategy diversification which smooths out drawdowns and returns. It is strategy diversification which keeps managers in the game and often gives investors the lower volatility desired. Strategy diversification can include trends, patterns, and fundamentals. The ways signals can be generated can be highly varied.

Trend-followers, for example, face drawdowns when trends are not present. These drawdowns can be severe. The reason for return failure is simple, there are no trends. A program that focuses on one phenomena will fail if that phenomena does not occur. There can be long periods when there are limited number or strength of trends for the simple reason the markets are in equilibrium. In this case using more than one strategy will smooth return profiles.

Along with strategy diversification is time diversification, looking at price behavior over different holding periods. The behavior of prices over a two week period may be very different than a two month period. The drivers of performance of the long-run will be more fundamental while short-run moves will be driven by flows.

Diversification into more markets may not be helpful if the markets do not have trends. Those markets that do have trends will have lower exposure or risk as more markets are added.  The result is muted returns on a fixed volatility. Diversification through the number roof markets can be a drag on performance. The only solution is add more strategies. Of course, adding more strategies will mute the positive value of trend-following. There will be less positive skew in a strategy diversified portfolio. Diversification has to be balanced with return. It cannot be looked at in isolation.