DoubleLine: How to Construct a ‘Better Mousetrap’ Trend-Following Portfolio

Diversification, said economist Harry Markowitz, is the “only free lunch in investing.” Markowitz invented Modern Portfolio Theory, which touts the virtue of diversifying a portfolio, geared to the risk involved.

But just how best to diversify has long been debated. The classic 60-40 mix (stocks and bonds) hasn’t worn too well this year when both asset classes are down.

DoubleLine Capital, celebrated for its fixed-income prowess, has an answer: create an ultra-diversified portfolio that tracks market momentum – best known in Wall Street circles as “trend following” – whether up or down.

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A study from the firm calls for piling 58 different components into the allocation, including all manner of equities (such as small-cap, emerging markets, the S&P 500), fixed income (U.S. Treasuries, Australian government bonds, British ones), commodities (oil, aluminum, gold), and currencies (British, Japanese, European). All are very liquid and have relatively small trading costs.

Together with French bank BNP Paribas, DoubleLine created an index to pack all these elements in together. The index employs strict risk controls to ensure that the portfolio stays in balance and doesn’t tilt too much in one direction. It does this by adding and subtracting leverage, depending on how much volatility a particular asset may encounter.

Known as the BNP Multi-Asset Trend Index, this collection appears to have fared well in recent crises, according to back-testing. Most of the time, it outpaced other alternatives. In the 2008 financial crisis, for instance, it returned 14%, compared with U.S. equities that were riding momentum (8%), presumably by shorting.

Calling the index “a better mousetrap,” meant to capture risk-adjusted returns instead of vermin, two DoubleLine staffers penned the research paper that the concept is based upon.

“By adding a trend-following strategy to a portfolio, investors can increase their diversification while also receiving the opportunity for a positive return,” write Deputy Chief Investment Officer Jeffrey Sherman and Quantitative Analyst Eric Dhall. “This allocation potentially increases the capital efficiency of the portfolio, raising the expected return per unit of risk taken.”

The dynamics of this index maintain what they call “the correlation structure between components.” This approach, they declare, “avoids the pitfall of going all in on any one sector or investment, a recipe for high volatility.”