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

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