Diversifying before the credit bubble pops

Key Markets report for Wednesday, July 23, 2025

In yesterday’s report (“An epic crash is inevitable”), I suggested that it was important for investors to diversify their risk away from equity markets which are in a colossal bubble, especially in the US, and could tip into a bear market at some point in the future. But if the credit expansion which boosted equity prices reverses, it will impact most other asset classes including bonds and real estate, so achieving real diversification really is a challenge.

Gold and bitcoin may seem like two obvious alternatives but in fact, the entire commodities complex should be considered, including industrial metals, energy (crude oil, heating oil, gasoline and natural gas) as well as agricultural commodities like grains, coffee, cocoa, cotton, and sugar. Gold and bitcoin could be crowded trades by now, but the prices of agricultural commodities and energy haven’t moved much at all.

The case for CTAs (commodity trading advisors)

Commodity trading advisors, also known as managed futures funds, are specialized fund managers who trade in a broad range of financial and commodities markets. As a rule, they use trend following strategies to gauge their directional exposure to markets. For qualified investors, a strategic allocation to a CTA fund should be an obvious choice. Some two years ago Sushil Wadhwani wrote an article titled, "The Case of Why Investors Should Diversify with CTA" published in the Financial Times.

Wadhwani is a fellow trend follower, CIO of PGIM Wadhwani and former member of the Bank of England Monetary Policy Committee, which all makes him a rare trend follower who is not an outsider to the institutional world of finance. The gist of Wadhwani's article will be familiar to longer-term subscribers to this newsletter: it reflects the same strategy and the same philosophy of investment management.

Diversification, exactly when it is most needed

Wadhwani pointed out that in 2022, during the last significant equities correction, a traditional investor portfolio of 60 per cent in equities and 40 per cent in bonds registered a double-digit percentage loss and added that, "We have seen such disappointing out-turns for a 60/40 portfolio before now during past periods of high inflation, such as 1973-74, and recessions, such as in 2008." By contrast, in 2022 CTA strategies, on average, registered double-digit gains after fees. This was not a fluke but a long-established merit of CTA (trend following) strategies.

Wadhwani continued: "We looked at the dozen worst periods over the last five decades for a 60/40 portfolio, in terms of its one-year losses, and how CTA funds performed in each episode (excluding our own funds). In 11 out of the 12 episodes, CTAs outperformed — and with an average gain of 19.9 per cent."

This quality is due to CTA strategies having the advantage of being agile — responding nimbly if the macroeconomic situation deteriorates. During the seven recessions identified by the US National Bureau of Economic Research since 1973, for example, CTAs have offered traditional investors much needed protection — with an average return of 11.6 percent per annum, thus outperforming a 60/40 portfolio 8.3 percentage points. It is quite clear that diversified trend following used by CTAs is practically the perfect portfolio diversifier for investors, in addition to being the single most effective inflation hedge.

Not just a rainy day strategy

But trend following isn't merely an insurance policy for rainy days - it is a resilient investment strategy for sunny days also. Writes Wadhwani: "It is important to not think of CTAs as akin to an insurance policy ... CTAs can and often do make money even when the sun is shining. When we look at the past 50 years of data, in periods when the 60/40 portfolio made money, so, generally, did CTAs — and at a healthy average annual rate of 8.6 per cent (using our index of CTA returns since 1973). This is because CTAs are often long equities during such periods.

The question the poses itself then is, why don't all investors have an allocation to this strategy? Wadhwani notes that investor allocation to CTA strategies is minimal and comments that, "The low allocation is puzzling to us but, in our experience, often relates to the desire on the part of trustees to not deviate too much from what is conventional." Indeed; I often get the question - well, if trend following is so great, why isn't everyone a trend follower? I think it would be a bit like if you discovered an effective homeopathic remedy to some ailment and proposed it to the World Health Organization or the healthcare industry. It would be rejected and it would not much matter how effective the remedy was: we just don't do homeopathy and that's that!

Patience, patience, patience!

In reading Wadhwani's article, I was happy to note that he underscored another theme that will ring familiar to readers of this newsletter: patience as an essential prerequisite for successful investing: "Most investment strategies suffer from drawdowns. Thus, investors need to be patient. This is true as much for CTA strategies as it is for “long-only” investments."

To learn more about TrendCompass reports please check our main TrendCompass web page. We encourage you to also have a read through our TrendCompass User Manual page. For U.S. investors: an investable, fully managed portfolio based on I-System TrendFollowing is available from our partner advisory (more about it here).

Today’s trading signals

With yesterday’s closing prices we have the following changes for the Key Markets portfolio: