Monday, January 6, 2020

Trend-following - Go deep or go wide - There is a balance on the number of markets traded

There are two key choices for building managed futures trend-following portfolios - going deep or wide with diversification. There are clear trade-offs with this choice. For 2019, the focused financial trend-followers, in general, did better than those that followed a strong diversification strategy. That strategy may not work in 2020. 

The go-wide diversification strategy - Trade as many market as possible. The investor gets the maximum amount of diversification and exposure to less liquid alternative commodity markets which often have a stronger tendency to see larger price moves than the more liquid markets. The portfolio cost is that there can be over diversification and higher transaction costs.

The go-deep diversification strategy - Trade only the most liquid markets which will allow for lower transaction costs but also has greater sector concentration. Bonds markets across the curve and across countries have high correlation. Global stock index markets are also highly correlated. The most liquid contracts are focused in the global equity index and bond markets. The cost of trading these markets is low based on the tight bid-ask spreads. 

Is one better portfolio strategy than the other? Simple theory may suggest that more diversification, that is more markets, should be better, but diversification is also a question of determining the marginal contribution of the next market added. If the additional markets are all highly correlated, adding more will not improve efficiency and just add complexity and costs. 

The other key portfolio question is whether there is a return advantage from adding less liquid commodity markets that will more than offset costs and complexity. There is some clear evidence that these small markets will add value. See "Trend's Not Dead (It's just moved to a trendier neighbourhood)" by the folks from Gresham Investment Management.

In their short paper, Gresham finds that autocorrelation terms (the sum of autocorrelations) of alternative commodity markets, (less liquid markets), are higher than that of liquid markets. There have also been more large moves with alternative markets relative to liquid markets. Finally, the chance of a large move has been greater for alternative commodity markets in the post Financial Crisis period relative to liquid markets that have seen a decrease in the number of large moves.

Unfortunately, as a trend-following firm gets more successful and larger, the size that can be traded in these small markets gets smaller. Large firms use the "go-deep" strategy because the "go-wide" is not available as an alternative. Still, a smaller firm that employs a "go-wide" strategy needs to have the technology and systems to manage the greater number of markets traded. 

Of course, the type of trading strategy will matter. A strategy that trades all markets with either long or short signals will suffer from dilution from trading more markets. A cross-sectional approach that trades only the best long and short trends will have an advantage of limited dilution but will still face liquidity issues. A portfolio construction technique that allocates a percentage of total exposure to each asset class can offset liquidity issues and concerns about marginal improvement from adding markets. 

The type of signals, the form of diversification, and the set of markets traded are all inter-related. These questions can be partially answered through a deeper quantitative analysis of specific choice. We wanted to call attention to key portfolio trade-off that needs to be explored.

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