Optimal trend following portfolios

TL;DR

This paper develops a unifying theoretical framework for trend-following portfolios, deriving an optimal portfolio that combines multiple strategies and is validated through empirical backtests across various assets.

Contribution

It introduces a comprehensive autocorrelation model for trends and risk premia, unifying and extending existing portfolio strategies into a single framework.

Findings

Optimal portfolio outperforms benchmarks in backtests

Decomposition into four basic portfolio components

Framework unifies and rationalizes previous portfolio strategies

Abstract

This paper derives an optimal portfolio that is based on trend-following signal. Building on an earlier related article, it provides a unifying theoretical setting to introduce an autocorrelation model with the covariance matrix of trends and risk premia. We specify practically relevant models for the covariance matrix of trends. The optimal portfolio is decomposed into four basic components that yield four basic portfolios: Markowitz, risk parity, agnostic risk parity, and trend following on risk parity. The overperformance of the proposed optimal portfolio, applied to cross-asset trading universe, is confirmed by empirical backtests. We provide thus a unifying framework to describe and rationalize earlier developed portfolios.