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.

Keywords: Risk parity, trend following,bhavioral finance, momentum, global asset allocation, equities, bonds, real estate, commodities

JEL Classification: G10,11,12