Optimal allocation of trend following strategies

We consider a portfolio allocation problem for trend following (TF) strategies on multiple correlated assets. Under simplifying assumptions of a Gaussian market and linear TF strategies, we derive analytical formulas for the mean and variance of the portfolio return. We construct then the optimal portfolio that maximizes risk-adjusted return by accounting for inter-asset correlations. The dynamic allocation problem for n assets is shown to be equivalent to the classical static allocation problem for n(2) virtual assets that include lead-lag corrections in positions of TF strategies. The respective roles of asset auto-correlations and inter-asset correlations are investigated in depth for the two-asset case and a sector model. In contrast to the principle of diversification suggesting to treat uncorrelated assets, we show that inter-asset correlations allow one to estimate apparent trends more reliably and to adjust the TF positions more efficiently. If properly accounted for, inter-asset correlations are not detetiorative but beneficial for portfolio management that can open new profit opportunities for trend followers. These concepts are illustrated using daily returns of three highly correlated futures markets: the E-mini S&P 500, Euro Stoxx 50 index, and the US 10-year T-note futures. (C) 2015 Elsevier B.V. All rights reserved.