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

Abstract

We examine applying a trend following methodology to global asset allocation between equities, bonds, commodities and real estate. This strategy offers substantial improvement in risk-adjusted performance compared to buy-and-hold portfolios and 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, and offers a solution to the inappropriate sequence of returns which can be problematic for decumulation portfolios. The other side of behavioural biases is that they may be exploited by investors: an example is momentum investing where herding leads to continuation of returns and has been identified across many assets. Momentum and trend following differ as the former is a relative concept and the latter absolute. Combining both can achieve the higher return levels associated with momentum portfolios with much reduced volatility and drawdowns due to trend following. Measures based on utility of a representative investor reinforce the superiority of combining trend following with momentum strategies. These techniques help address the sequencing of returns issue which can be a serious issue for financial planning.