Enhancing Trend Following Performance using System Diversification

While it's common to discuss diversification in terms of the wide range of markets trend followers engage in, diversifying the systems or models they use is equally crucial. This approach not only helps in lowering portfolio volatility but also enhances the potential to capitalize on exceptional market movements, often referred to as 'Outliers'.


Let's delve into some key aspects of system diversification, specifically the practice of applying various trend following models to the same market. By exploring this strategy, I aim to outline its advantages and disadvantages, especially when contrasted with the more traditional approach of applying a single system to a single market. This comparison will shed light on how different models can complement each other to capture diverse market dynamics, offering a broader perspective on effective diversification strategies.


System Diversification Allows you to Reduce Portfolio Volatility


System diversification in trend following involves deploying a variety of models within the same market to create a composite of strategies that can offset correlations and enhance the ability to tap into diverse market opportunities. This approach contrasts with dedicating 100% of capital to a single strategy within a single market, which typically results in a return stream characterized by the volatility and performance tied to how that specific system interacts with market trends over time.


By allocating, for instance, 10% of capital to each of 10 distinct trend following models within the same market, an investor generates multiple return streams. Each stream reflects the unique way its corresponding model engages with the market's trending behaviours. This ensemble of models produces a set of results with inherent correlation offsets, leading to reduced overall volatility and potentially capturing a broader array of trending opportunities due to the reduced reliance on any single model's selection bias.


The traditional method of selecting a single trend following model based on its historical performance introduces a risk of selection bias and curve fitting, as the chosen model is typically the one that performed best in backtesting. This can lead to overoptimization to past market conditions, reducing the model's effectiveness in future, unforeseen market environments. In contrast, employing an ensemble of models mitigates this risk, as the collective approach is less likely to be overfitted to historical data and more adaptable to a range of market conditions.


Each model within the ensemble adheres to the core principles of trend following—cutting losses quickly while allowing profits to run—but is uniquely configured to respond to different trend durations and patterns. This diversity within the ensemble equips it to handle a wide variety of trend scenarios, making it metaphorically the most 'flexibly fitting' approach in the trend following space.


The ensemble strategy is particularly effective in capturing trends that emerge in the extreme 'fat tail' regions of market return distributions, where outliers reside. These outliers represent unpredictable, high-impact events that defy standard categorization. By employing a broad ensemble of trend following models, there's a higher likelihood of harnessing the gains from these rare but significant events, while maintaining the discipline to cut losses swiftly and avoid the pitfalls of adverse tail events.


Using System Diversification to Have More Direct Control over Portfolio Correlations 


System diversification offers a strategic approach to managing correlations, distinct from the inherent correlations present between different markets. While market correlations are largely beyond our control, dictated by external market dynamics, system diversification allows for deliberate manipulation of correlations through the design and configuration of trading systems.


An illustrative example of this control is the concept of a perfect hedge within a single market, where buying and selling a contract simultaneously can, theoretically, result in perfectly negative correlations, nullifying market risk aside from transaction costs. However, while a perfect hedge demonstrates the potential to neutralize market risk, it does not inherently generate long-term returns.


To leverage system diversification for returns, the approach needs refinement. Systems must be designed with a persistent edge, and when combined, they should significantly dilute market correlations. Employing an ensemble of systems enables the strategic activation and deactivation of individual systems based on specific entry criteria, ensuring that they operate independently of one another at different times. This staggered activation contributes to a composite system with more uncorrelated characteristics, enhancing the ensemble's ability to navigate diverse market conditions effectively.


System Diversification Allows you to Expand in Terms of Market Diversification


The effectiveness of capturing opportunities from market trends hinges on two pivotal elements: the inherent trends within the market and the capability of our trading systems to seize these opportunities. Utilizing an ensemble of trend following systems broadens our ability to identify and exploit Outliers across the market's time series, enhancing the potential for significant returns.


An Outlier trade is the product of the dynamic interplay between distinctive market trends, which may themselves be Outliers, and the specific design and responsiveness of our system's architecture to these market conditions. Certain systems, by virtue of their design characteristics, are particularly adept at capitalizing on market trends, achieving exceptional reward-to-risk outcomes.


Incorporating a variety of systems into an ensemble not only increases the likelihood of engaging with Outlier opportunities but also introduces a diverse range of responses to similar market conditions. Minor differences in system design can result in one system capturing an Outlier trade while another might not, underscoring the value of diversity within the ensemble.


The real power of a system ensemble becomes evident when applied to highly correlated markets. For example, when an ensemble of Trend Following systems is employed across two markets with high correlation, such as Brent Oil and Crude Oil, the resulting return streams from the ensemble exhibit significantly lower correlation than the markets themselves. This reduction in correlation is a testament to the ensemble's ability to diversify risk and enhance returns, even in markets that traditionally move in tandem.


This unique attribute of system diversification allows for a significant expansion in market engagement within a portfolio context. By effectively dismantling the inherent market correlations through the use of system ensembles, traders can vastly increase the number of markets they participate in. System diversification, therefore, not only mitigates risk through broader market coverage but also amplifies the potential for capturing lucrative market movements, paving the way for a more robust and resilient trading strategy.


Leveraging Trends with a Staggered Ensemble Approach 


Employing an ensemble of trend following systems to engage with a single market introduces a dynamic method of participation that is responsive to the evolving conditions of market trends. Each system within the ensemble is designed to activate based on specific entry conditions, leading to a staggered approach to trend engagement. This methodical entry into the market means that investment is not committed all at once at the onset of a potential trend, but rather progressively, as the trend demonstrates material development and strength.


This strategy bears resemblance to the technique of pyramiding, where additional positions are added to a winning trade as the trend continues to prove itself, thus effectively leveraging the trend's momentum for enhanced performance. This approach not only maximizes potential returns as the trend grows but also aligns with prudent risk management practices, ensuring that capital is committed in a controlled, deliberate manner.


A key feature of the ensemble approach is its inherent risk mitigation. Each system within the ensemble is designed to strictly control adverse risk, safeguarding realized capital at all times. This foundational principle of capital preservation allows the ensemble strategy to leverage unrealized capital—profits that have been accrued on paper but not yet realized—into developing trends. It's akin to "swinging for the fences" in baseball, where the security of the realized capital emboldens the strategy to aim for substantial returns.


By employing multiple systems, each with its unique criteria for trend engagement, the ensemble approach facilitates a powerful mechanism for amplifying returns. This strategy can lead to significant Outlier trades when market conditions align favourably, effectively multiplying performance through the collective strength and diversity of the system ensemble. This method not only enhances the potential for capturing lucrative market movements but also reinforces the resilience and adaptability of the investment strategy in the face of market volatility.


Conclusions 


System diversification stands out as a pivotal strategy for trend followers seeking to optimize their trading approaches. By integrating multiple trend following models within the same market, traders can significantly enhance their ability to navigate the complexities and volatilities of financial markets. This method offers a robust framework for reducing portfolio volatility, mitigating the risks of selection bias and overfitting, and increasing the chances of capturing lucrative Outliers.


The practice of system diversification transcends the conventional wisdom of market diversification, presenting a more nuanced and dynamic approach to trend following. It allows traders to exert greater control over portfolio correlations, tailor their strategies to mitigate inherent market risks, and seize opportunities presented by diverse market dynamics. By employing an ensemble of models, each tailored to different aspects of market trends, traders can create a more resilient and adaptable trading strategy capable of weathering market uncertainties and capitalizing on emergent opportunities.


Moreover, the staggered engagement approach inherent in system diversification mirrors the prudent principles of risk management and capital preservation. This strategy not only safeguards realized capital but also leverages unrealized gains to maximize potential returns, embodying the essence of 'swinging for the fences' while maintaining a firm grip on risk.


Ultimately, the adoption of system diversification within trend following heralds a sophisticated and forward-thinking approach to trading. It underscores the importance of innovation, adaptability, and strategic planning in the pursuit of trading excellence. As the financial markets continue to evolve, so too must the strategies employed by those who navigate them. System diversification offers a path forward, promising a blend of risk management and return potential that is well-suited to the challenges and opportunities of modern trading landscapes.


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