Diversifying Trends

Abstract

A new method is proposed for disentangling the systematic components from the idiosyncratic components of risk associated with trend-following strategies. A simple statistical approach combined with standard dimension reduction techniques enables to identify the common trending component of futures market prices. This methodology is applied to a large set of futures, covering all asset classes, to extract a common risk factor, called CoTrend. It is shown that common trends are higher for some cross-asset class pairs than for intra-asset class pairs, such as JPY/USD and Gold. This result is used to create sectors in a portfolio diversification context, especially for trend-following strategies. Additionally, the CoTrend factor helps understand arbitrage-based Hedge Fund strategies, which by essence are decorrelated from standard risk factors.