European Equity Investing Through the Financial Crisis: Can Risk Parity, Momentum or Trend Following Help to Reduce Tail Risk?

32 Pages Posted: 23 Jan 2014 Last revised: 24 Jan 2014

See all articles by Andrew Clare

Andrew Clare

City University London - Sir John Cass Business School

James Seaton

City University London - Sir John Cass Business School

Peter N. Smith

University of York - Department of Economics and Related Studies; Australian National University (ANU) - Centre for Applied Macroeconomic Analysis (CAMA)

Steve Thomas

City University London - Sir John Cass Business School

Multiple version iconThere are 2 versions of this paper

Date Written: December 1, 2013

Abstract

A growing body of literature suggests that over widely varying historical eras and across a wide range of asset classes momentum investing, often accompanied by a trend following overlay, provides superior risk-adjusted returns. We examine the effectiveness of applying these methodologies to pan-European equity asset allocation through periods of potentially substantial market dislocation, in particular, with the advent of the single currency and the equity market crashes of the early 2000's and 2008. With the introduction of the Euro there has been much discussion of the benefits of diversification via country based portfolios versus industry sector portfolios. Early studies simply looked at changing return correlations over time. The simple conclusion that increasing country correlations over time drives superior risk-adjusted portfolios towards diversification across sectors has been increasingly challenged. Our approach is different in that we apply momentum and trend following investing strategies and assess whether it is sectoral or country indices which dominate our portfolios through periods of structural changes and extreme volatility. Diversification via sectors is clearly the best strategy in times of equity market stress. In addition, the application of trend following offers a substantial improvement in risk-adjusted performance compared to traditional buy-and-hold portfolios. The terms 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, tail risk and drawdowns due to trend following. We observe that a flexible asset allocation strategy that allocates capital to the best performing instruments irrespective of asset class enhances this further. Such methodologies offer superior risk adjusted returns, especially through periods of raised market volatility.

Keywords: Trend following, Momentum investing, Tail risk, European equity sectors, Financial crisis

Suggested Citation

Clare, Andrew D. and Seaton, James and Smith, Peter N. and Thomas, Stephen H., European Equity Investing Through the Financial Crisis: Can Risk Parity, Momentum or Trend Following Help to Reduce Tail Risk? (December 1, 2013). CAMA Working Paper No. 8/2014. Available at SSRN: https://ssrn.com/abstract=2382973 or http://dx.doi.org/10.2139/ssrn.2382973

Andrew D. Clare

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

James Seaton

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Peter N. Smith (Contact Author)

University of York - Department of Economics and Related Studies ( email )

Heslington
York 010 5DD
United Kingdom
+44 1904 433 765 (Phone)
+44 1904 433 759 (Fax)

Australian National University (ANU) - Centre for Applied Macroeconomic Analysis (CAMA) ( email )

ANU College of Business and Economics
Canberra, Australian Capital Territory 0200
Australia

Stephen H. Thomas

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 (0) 20 7040 5271 (Phone)
+44 (0) 20 7040 8881 (Fax)

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