However, the post-2008 financial crisis period presented a puzzling anomaly. Despite prior success, trend-following strategies underperformed significantly between 2009 and 2013. This unexpected decline prompted a deeper investigation into the factors affecting trend-following efficacy during this era.

In his paper, “Trend-Following, Risk-Parity and the Influence of Correlations,” Nick Baltas explores this conundrum. He examines how unusual correlations across asset classes may have undermined traditional volatility-parity weighting schemes, which assign portfolio weights inversely proportional to each asset’s volatility while ignoring how assets move in relation to each other. Baltas proposes an alternative: extending the risk-parity framework—commonly used in long-only portfolios – to accommodate long-short positions in trend-following strategies.

To address these challenges, Baltas advocates for a risk-parity approach that accounts for both volatility and correlations, allocating risk more evenly across the portfolio. This method adjusts for the increased interconnectedness of markets, leading to improved performance in varied correlation regimes.

Figure 2 illustrates that the risk-parity trend-following strategy consistently outperforms its volatility-parity counterpart, particularly in extreme correlation environments where the Sharpe ratio more than doubles. By incorporating correlations into the portfolio construction process, the risk-parity approach enhances capital efficiency through the effective use of leverage and optimizes the combination of assets across various classes.

This methodology aligns with the principles of portable alpha, where uncorrelated strategies are overlaid to generate additional returns without a proportional increase in risk. For a deeper exploration of portable alpha strategies, refer to Portable Alpha: Leveraging Uncorrelated Strategies.

Baltas’s findings have significant implications for the concept of return stacking. While his paper focuses on trend-following, the emphasis on managing correlations and employing sophisticated weighting schemes resonates with the core principles of return stacking.

Return stacking involves layering multiple, differentiated return streams—such as managed futures, carry strategies, or alternative yield sources—into a single portfolio. This approach aims to enhance diversification, reduce volatility, and achieve higher risk-adjusted returns compared to traditional portfolios. By effectively combining uncorrelated assets, investors can create portfolios that are more resilient to market downturns.

The necessity of accounting for correlations, as highlighted by Baltas, is paramount in return stacked portfolios. Ignoring asset interrelationships can lead to unintended risk concentrations, undermining diversification efforts. Incorporating a risk-parity framework ensures that risk is more evenly distributed, aligning with the goals of return stacking.

Furthermore, Baltas’s research underscores the importance of dynamic risk management. Static allocation strategies may falter in volatile markets, whereas adaptive strategies that adjust to changing correlation regimes can maintain alignment with investment objectives. This adaptability is a key component of successful return stacking.

Investors interested in integrating trend-following into their return stacked portfolios can explore how managed futures play a role in this context. For more information, see Managed Futures: Trend Following.

For investors practicing return stacking, these insights reinforce the importance of sophisticated portfolio construction techniques. Managing correlations effectively and employing dynamic risk management are essential for building resilient portfolios capable of navigating interconnected markets.

In conclusion, embracing advanced strategies like risk-parity weighting in trend-following not only addresses the shortcomings observed in post-crisis performance but also aligns with the broader objectives of return stacking. As markets continue to evolve, adopting such adaptive and risk-aware approaches is crucial for achieving long-term investment success.