Risk Parity with Trend-Following

Risk-parity is a widely understood strategy that performed very well in the post-Volcker era of declining interest rates. However, a traditional risk-parity strategy using stocks and bonds is vulnerable to periods like 2022 when both asset classes entered a simultaneous drawdown, as inflation caused the correlation between them to switch positive for the first time in over a decade. We propose that an improved approach to risk parity may be implemented by either replacing or augmenting long-duration bonds with a trend-following strategy. Our results strongly suggest that including trend-following in either capacity improves upon classical risk parity, especially when carry considerations are included. For robustness, we show that this is still the case even when we include an allocation to commodities in the traditional risk-parity portfolio. This asset class not only historically has performed well during periods of inflation, but also performed well during 2022.