The folks at Quantica Capital have generated a provocative study called, "When trend-following hits capacity: A case study on commodities, exploring the hidden opportunities of limited investment universe diversification". Given the growth in trend-following programs, it is important to think about the issue of capacity. This is once again the age-old question of how many markets should you trade and what is the value of trading more markets.
Quantica finds that the top ten markets in liquidity represent about 70% of the total available commodity futures liquidity. It is not exactly clear how liquidity is measured but the intuition makes sense. Energy futures dominate commodity futures liquidity along with gold, silver, and soybeans. All the other markets will be harder to trade. This is important because many of the futures that are not in the top ten provide significant diversification. We can measure the value of diversification through a simple measure of the Sharpe ratio is sum of individual Sharpe ratios for each market times the diversification multiplier that is related to the average correlation across markets and the number of markets in the portfolio. There is significant value with moving beyond the top ten markets even though you may not have better trend characteristics and there is less liquidity. Diversification is a benefit unto itself. You pay with lower liquidity, but you get the strongest diversification benefits from commodities. There is no guarantee of higher returns from holding more markets, but you get a strong tailwind from diversification.
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