Is Your Trend Following Portfolio Diversified Enough?

Adopting a trend following approach may only be the first step toward achieving robust portfolio diversification.

As most experienced investors know, the best market analysis can’t project far beyond the present. The same can be said of fund performance statistics. Both can tell you about what’s happening now (with a market or fund), how they got there, and perhaps where they might be heading. But neither can guarantee an outcome. And that’s why investors diversify their assets.

As most experienced investors know, the best market analysis can’t project far beyond the present. The same can be said of fund performance statistics. Both can tell you about what’s happening now (with a market or fund), how they got there, and perhaps where they might be heading. But neither can guarantee an outcome. And that’s why investors diversify their assets.

Diversifying Within and Across Commodities

Many investors who turn to commodity futures do so in order to diversify their exposure to the equity markets. It’s about market diversification or asset class diversification. After all, the economic drivers affecting equities are not necessarily the same ones driving commodities such as natural gas, soybeans, copper, or livestock. And among the investors who “invest” in commodities without actively trading them, many adopt a trend following system, whether their accounts are self-directed or managed.

But here’s an important question: is this type of market or asset class diversification sufficient enough to capture broader market opportunities and mitigate risks due to over-concentration? It might not be. What if your particular trend following system or methodology, which may have performed well over the years, starts to underperform? How will you know if the system will ever recover? Some trend following systems don’t recover for years or decades.

If you diversify across trend following systems, however, you won’t necessarily need to worry about it. After all, every market trends in the long run. The problem is often not in the trend, but in the “following”–that’s where errors and bad assumptions lead to poor results.

The solution that most investors might benefit from is not diversification at the market level, nor asset level, but at the “system” level. System diversification may be a critical step toward developing a more robust trend following “portfolio”.

System Diversification and Trend Following

In the mid-20th century, Richard Donchian, one of the originators of technical trend following, developed a trading method based on the 5-day and 20-day moving average. If you don’t know what a moving average is, it’s basically the average of prices over a given time period (e.g. five days and twenty days, respectively). He discovered that an investor can make money if she buys an asset that breaks above its 20-day average, selling the same position if it closes below the 5-day average. This is a simplistic example, of course, but it illustrates the general idea.

Donchian’s original formulation might have worked at the time he first developed it, but it began to underperform as markets gradually became noiser and more globally accessible in the years following his initial discovery. Moving averages still work today, as they reveal (however lagging) the overall price trend. But the question is which moving average (or set of moving averages) might work best.

The simple answer is that you can never know. Hence the need for a diversification method that aims to capture the best outcomes within a given approach–in other words, system diversification.

S&P 500 Futures – Weekly Chart – June 2002 to October 2019

Take a look at the S&P 500 futures (ES) weekly chart above and take note of the two colored lines. The blue line represents the 50-week moving average of prices. The orange line represents the 200-week price moving average.

Let’s suppose your trend following system was based solely on price crossovers–meaning, you would buy if price crossed above a given moving average and sell short if price crossed below the average. (Note that there are many approaches to trend following, the following being a simplified version of one approach; nevertheless, the following hypothetical example aims to describe a principle that applies to almost all approaches, regardless of simplicity or sophistication).

As we’ll see, both moving averages present their own unique advantages and disadvantages:

  • The 50-week might have gotten you in a long position at [1] as the ES recovered from the Tech Bubble of 2000. The 200-week average might have signalled a “buy” two years later.
  • In 2007, the year leading up to the crash that kicked off the Great Recession, the 50-day might have provided an early-warning signal to go “short” the market at [1]. The 200-week average signalled a short entry 3-6 months later.
  • When the S&P 500 bottomed in 2009, the 50-week moving average once again provided an entry signal to go long that same year, unlike the 200-week moving average whose signal came late in November 2010–an “iffy” signal since the 200-week average was lagging and trending downward.
  • But here’s the downside: the 50-week moving average was also subject to a frequent bout of “whipsaws” which are false signals that can cause a trend following system to sustain losses (see red circles).
  • In the meantime, the 200-week moving average, though lagging and late in both entry and exit signals, might have done a better job capturing the long-term trend [4] while avoiding most of the whipsaws experienced by the faster moving average.

So the trade-off is such that the faster average was more sensitive to trend changes but more vulnerable to whipsaws, while the slower average was less sensitive to trend changes but capable of capturing the “big move”.

The kicker is that as a trend follower, you would not have been able to predict which moving average was destined to perform better. And if you were stuck with one approach, you might have missed out on the better-performing variation.

Stacking the Odds in Your Favor by Diversifying the System

Sticking to our moving average system, you cannot tell which calculation might outperform or underperform in the future.

Will you be better off with the 25-week, 50-week, 80-week, 100-week moving average and so forth? Perhaps the solution might be to divide your capital and allocate it equally across a range of different system approaches. Of course, the system you choose must either have performed or tested well in the past.

By diversifying your capital in this manner, you may not get the “one” approach that captures the best returns in the long-run, but neither will you get stuck with the worst-performing system that yields only negative returns. You are diversifying your funds to cast a wide net on profit potential while mitigating your system risks. After all, that’s what diversification is about. And by adding system diversification to your market and asset diversification strategy, you may achieve a much more robust portfolio capable of weathering a wider range of market conditions more effectively in the long run.