The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation

Abstract

We examine the effectiveness of applying a trend following methodology to global asset allocation between equities, bonds, commodities and real estate. The application of trend following offers a substantial improvement in risk-adjusted performance compared to traditional buy-and-hold portfolios. We also find it to be a superior method of asset allocation than risk parity. We believe the discipline of trend following overcomes many of the behavioural biases investors succumb to, such as regret and herding. The other side of behavioural biases is that they may be exploited by investors: the clearest example of this is momentum investing where herding leads to continuation of returns and has been identified across many asset classes. Also, momentum and trend following have often been used interchangeably although the former is a relative concept and the latter absolute. By combining the two we find that one can achieve the higher return levels associated with momentum portfolios but with much reduced volatility and drawdowns due to trend following. We compare the performance of selected strategies using measures based on the utility function of a representative investor. These results reinforce the superiority of combining trend following with momentum strategies. We observe that a flexible asset allocation strategy that allocates capital to the best performing instruments irrespective of asset class enhances this further.

Size Matters: Tail Risk, Momentum and Trend Following in International Equity Portfolios

“…We also find though, that volatility is now higher than trend following alone and that this cancels out the increase in return such that Sharpe ratio levels are largely unchanged in aggregate. This supports the results of Clare et al (2012). In addition to the higher volatility there is also an increase in the maximum drawdowns that most portfolios are forced to endure.…”

“…The risk-adjusted performance of these approaches has been a significant improvement on benchmark buy-and-hold portfolios. In a related study we extend these ideas to the multi-asset context (Clare et al, 2012) and find that although adding a momentum filter increases the level of return compared to equal weighting, the momentum portfolios are prone to large drawdowns. By contrast they find that trend following filters produce higher Sharpe ratios than the momentum-based equivalents, higher Sharpe ratios and, crucially, much lower maximum drawdowns.…”

Can sector-specific REIT strategies outperform a diversified benchmark?

“…Indeed, Hurst et al (2012, p.2) make the following distinction: Evidence for the effectiveness of trend following strategies has been presented by Faber (2007), ap Gwilym et al (2010) and Moskowitz et al (2012), amongst others. Clare et al (2016) demonstrate that when relative momentum is compared to trend following it is the latter that provides by far the more impressive investment performance enhancement for a variety of asset classes. Moskowitz et al (2012) find significant ''time series momentum'' in equity index, currency, commodity and bond futures for each of the 58 liquid instruments considered.…”

“…An extensive literature is available that describes simple mechanical rules that can be used as an overlay on existing portfolios. For examples, see Faber (2007) and Clare et al (2016) for multi-asset, Szacmary et al (2010) for commodities and Moss et al (2015) for real estate whilst Hurst et al (2012) report for over 200 years of data using futures markets.…”

Volatility Weighting Applied to Momentum Strategies

“…Moskowitz, Ooi, and Pedersen [2012] studied time-series momentum in futures markets and used normalized returns, but they did not study the effect of doing so. Clare et al [2016] also considered the use of normalized returns for equally weighted portfolios and momentum strategies in the context of asset allocation. They found volatility weighting to be useful across (but not within) asset classes for the equal-weighted portfolio and that using normalized returns is beneficial for trend following.…”