Saturday, April 9, 2016

Fading volatility is a strategy that works

Volatility matters. Portfolio efficiency focuses on the return to risk trade-off. There has been a focus on low volatility strategies, but just as important is the idea that when volatility is high or increasing, investors should be walking away from risk. Adapting or adjusting to volatility is a dynamic concept. In simple terms, investors are often not compensated for shocks or increases in volatility. The low volatility argument is that investors are not compensated when volatility is high. Investors do not receive enough return compensation for either level of changes in volatility to keep their Sharpe ratios stable.

Given this viewpoint, along comes a very interesting paper, Volatility Managed Portfolios, by Alan Moreira ad Tyler Muir. The authors show that dynamic adjustment of portfolio exposures with respect to volatility will add to the portfolio's overall Sharpe ratio. If volatility is high, cut the risk exposure to that asset or factor. 

This is contrary to traditional thinking which says that there is risk return trade-off such that higher risk will be offset by higher return. What the authors find is that the response of return is slow relative to a shock to volatility. If volatility spikes, cut the exposure. As the volatility comes down, you can go back and increase exposure and you will still benefit. This applies even after accounting for well-known factors. 

What is very interesting is that this works even during periods of recession. Volatility will increase during periods of recession or "bad times". You will also be compensated for risk by buying risky assets during bad times but the timing of these two relationships is not the same. Hence, volatility timing can add value and you can still hold the relationship that returns will be higher in periods of recession.

This makes sense although you need to see the numbers and get comfortable with the fact that changes in risk do not immediately translate into changes in return. Volatility is forecastable over relatively short horizons while returns are not. This means that investors can exploit volatility shocks. 

On a risk-adjusted basis, investors are worried about risk and return. If you can make good volatility choices and cut high volatility, you are able to increase the mean variance ratio.  This is research that is easy to implement and have a meaningful positive impact for investors.

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