Stephen Wood explains why a single well-researched trend-following investment model can produce better results than simply relying on diversification using different models
Investors typically seek to exploit the power of diversification: it is possible to improve risk-adjusted returns simply by combining different diversifying strategies of similar risk and return. As this is an ongoing challenge for investors, we looked at whether this approach should also be applied to trend-following models. Such models are typically used by managed futures managers that apply a systematic approach to capturing trends, both upward and downward, in a broad and diversified range of asset classes and markets.
There are many different methods of creating trend-following models. We considered a wide range of common approaches to investigate whether the combination of several of these models can lead to improved performance. Alternatively, we examined whether there is a better way to construct a trend-following system.
Ultimately, the findings show how different trend-following models, when applied to the same portfolio of markets and operated at similar speeds, generally have high correlations with each other and so offer only limited diversification benefits. A better approach to trend following is to apply a holistic methodology that aims to capture the most effective features of many different techniques and to integrate them in a single high-calibre model.
Thirteen trend-following models were considered in the analysis, all applied to the same portfolio of markets and set to capture medium-term trends of approximately 2-3 months. The origins of these models are varied, and include models popularised by the ‘Turtle traders’, the legendary systematic traders initially taught by Richard Dennis in Chicago in the early 1980s. Also included are several models regularly cited in academic literature, and several other well-known trend-capture techniques. While these 13 models represent a broad range of different approaches to systematic medium-term trend capture, they are highly correlated to each other, as shown in the table. The lowest correlation is 67%, while the average is 89%.
As a consequence of the high levels of correlation between the individual models, the diversification benefit that arises from combining them is slight. The analysis goes further, considering all possible equally weighted combinations of the 13 models, to investigate the impact on performance as the number of models combined is varied. Again we find that there is little diversification benefit to be had from combining models.
There are good reasons to apply an integrated methodology to trend following. If the goal is to maximise performance from trend following, it is better to build the best possible single trend-following model that integrates distinguishing features of many different approaches. Systematic investment research should continuously lead to innovations across the various elements of a single holistic model. These elements include the processing of market data, the measurement of trends, and the method used to determine position sizes based on trend strengths.
We compared the 13 models with a proprietary, holistic trend-following model. This single model significantly outperforms all of the 13 models over the period. The performance of the averaged strategy is comparable to the performance of some of the individual models. This reflects the limited diversification benefit that comes from combining trend-following models.
The results support the argument that if the goal is to maximise performance from trend following, it is better to build the best possible single trend-following model that integrates features of various approaches rather than rely on diversification from different models. In essence, the number of individual trend-following models that comprise a trend-following portfolio is not in itself a measure of its superiority: the best approach is to focus on building a single, well-researched trend-following model.
Dr Stephen Wood is senior product manager at Aspect Capital