Monday, July 6, 2020

I want my CTA diversified but not too diversified

"I want my trend-follower diversified to smooth returns, but not too diversified..."

Diversification for trend-followers works at smoothing returns and increasing the Sharpe ratio. Diversification, through increasing the number of markets, increases the set of potential opportunities; however, diversification causes a drag on performance when only a limited number of markets trend. 

Some of the wide dispersion across trend-followers in 2020 is related to the market selection skill of the manager. Managers who traded too many markets, some of which did not see strong trends, may not have performed as well as those that had more concentrated risk. Similarly, focused managers may have missed the best opportunities of the year.

One secret to effective trend-following is the strong benefit from market sectors being correlated.  Global bonds and rates moving together, equity indices trending together, currencies tied to a dollar move, and the energy sector facing a common shock. The full value from trend-following comes when there is a common trend within a sector (allocation breath) or strong trend amplitude. A strong market trend is profitable but there is a limit based on the size of market exposure.

Following the fundamental law of active management, the information ratio = skill * sqrt(breath). A manager has to see an increase the number of bets or an increase is skill. For  any trend-follower, there are three trade buckets: the winners, scratch trades, and losers which are capped by stop-loss. The size and number of winners have to offset the scratch and loser trades.

The winners are associated with identifying the trend and the amplitude of the price move which may be out of their control. Skill or the information coefficient is identified as the correlation between forecasted and actual returns, but this can be restated at the win to loss ratio for trades times the probability of success. This success ratio can be multiplied by the number of trades to obtain the winners. 

Trading more markets allows the trend-followers to find more trends, yet if there the number of trends decline, there will a larger performance drag. Adding markets has to be based on the assumption that the marginal addition will increase the potential number of trends. For example, adding another commodity market with a risk allocation taken from other markets may not add to the return potential of the program. It will add to diversification. 

Investor to ask some simple question of their trend-followers. How do you determine the number of markets traded? Why would you add another market to the program? Would you ever drop markets from the program? Do you rank order and select trades from a broader universe of markets? 

Just as the trend model is critical, the choice and mix of markets for any trend-follower is an important part of the manager skill. Selecting trends and markets and sizing exposures are complex issues that serve to differentiate managers. Finding the right amount of diversification is an important portfolio selection issue.


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