Measuring Instrument Diversification in Trend-Following Portfolios

Summary

The document explains how diversification across futures markets can increase the risk-adjusted performance of systematic strategies. It defines effective independent bets by comparing a portfolio’s risk reduction with what would result from the same number of uncorrelated return streams. Because correlations and portfolio weights both matter, the author distinguishes expected diversification, calculated from the correlation matrix, from realized diversification inferred from Sharpe ratios. The analysis uses random market subsets and compares optimized weights with equal weights.

Using data for 102 instruments, the author compares a constant-forecast long-only portfolio with a trend-following portfolio using one EWMAC rule. Reported results indicate that trend-following returns across markets are less correlated than the underlying instrument returns, and diversification continues to help at larger market counts; the long-only portfolio’s benefit levels off sooner. The author cautions that optimized weights maximize the reported diversification measure, equal weights may be unsuitable for heterogeneous markets, and adding instruments requires capital or a separate sizing method. Results depend on the instrument universe, strategy, weighting choices, and methodology.

Key ideas

• Effective independent bets translate portfolio risk reduction into an equivalent count of uncorrelated return streams.
• Expected diversification depends on the full correlation matrix and actual portfolio weights.
• The analysis compares random market subsets using optimized and equal instrument weights.
• Trend-following returns across instruments are reported as less correlated than underlying instrument returns.
• The reported diversification benefit is sensitive to weighting choices and requires capital to access more markets.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.