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High flyers...

High flyers...

Long-term listeners of our Systematic Investor podcast series know that there are several topics we like to revisit.

One of them is the “dividing” debate about dynamic volatility scaling of positions. The other one is, of course, discussing the undisputed benefits of diversification.
Without doing a scientific study…the word “diversification” is probably in the top 3 most used technical terms on the podcast.

Now, let’s get to the core of it – why is diversification good? By its very definition, diversification entails that at any point in time there will be parts of your portfolio that will underperform. Why waste good capital (and/or risk) on something that underperforms? Doesn’t it make sense to forecast how your positions will perform and then rotate away from those you expect to lose?

If you are capable of doing these forecasts, then it makes perfect sense to move away from assets that will lose money and invest only in the profitable ones. But then again, if you are capable of such forecasts, you probably won’t be reading this blog post because you’d be too busy drinking your cocktail on a tropical island that bought with your trading gains.
For the rest of us simple mortals, the harsh reality is that market timing has proved to be a very low Sharpe Ratio strategy. Since producing accurate forecasts on future expected returns is inherently difficult, the best approach is to avoid putting all of your eggs in one basket, which means diversifying as broadly as possible.

Trend Following systems are, in a way, the perfect expression of this idea. Trend Following goes as far as to say that it’s practically impossible to predict any future returns. This is why, in essence, the very best strategies focus on achieving as high a level of diversification as possible.

The recent strong performance of the Trend Following industry has been a perfect example of the benefits of diversification. You see, many people think that the reason for Trend Following’s recent success has been the price action in the commodities space. This is only partially true. In fact, if you look at Trend Following’s performance drivers over the last 5 months, you will see that the sectors that contributed positively rotated through time – sometimes it has been commodities, other times it was short rates, and more recently it has been the currencies.

In essence, Trend Following’s level of diversification has ensured that there is always at least one high flyer – an asset class that supports performance.

Our guest in this week’s episode of the Systematic Investor podcast series was Alan Dunne who explained this performance dynamic along with many other interesting topics.

We warmly invite you to tune into this week’s episode and as usual, we promise your spend your time well listening to it!