Risk- versus Trend-Driven Global Tactical
Asset Allocation

Abstract

The 2008 financial crisis has severely challenged passive forms of investment. In this article, the authors compare two systematic investment processes that a global asset allocator may employ to preserve its capital in a turbulent financial environment. The risk-driven allocation, derived from the popular risk-parity approach, has garnered a strong interest from both scholars and practitioners in recent years. It aims at enforcing a constant risk target and maintaining a balanced risk profile over time. This article introduces a novel trend-driven approach that enhances the risk-driven strategy by cutting exposure to downward-drifting assets. The authors compare the risk-adjusted performances of risk- and trend-driven approaches on different investment universes (composed of equity, commodity, currency, and bond futures contracts) from 1993 to 2012. They find that a trend-driven approach yields increased Sharpe ratios and lower drawdowns on average, relative to a risk-driven strategy. However, the trend-driven process’s outperformance is not stable over time: periods with exploitable trends alternate with long-lasting trendless periods. Overall, the trending strategy’s key advantage over the risk-driven one is its greater smoothness. This is due to a better resilience to financial meltdowns like those seen from 2000 to 2002 and in 2008, which are well predicted by trending signals and undermine the diversification objective the risk-parity approach pursues. These results demonstrate the value of coupling risk and trajectorial signals in tactical asset allocation.

TOPICS: Financial crises and financial market history, portfolio construction, volatility measures