Friday, February 17, 2017

It is all about the volatility management

For many investment strategies, the difference between a good and a bad manager is based on their ability to manage risk. It is as much about how volatility is handled as return generation. A good strategy which does not manage risk well will never be truly successful. 

A key conclusion from a recent paper that focuses on volatility and factor management show that controlling volatility provides significant enhancement for many factor-based strategies. If you control volatility, you will get a positive bump in the return to risk ratio. 

This is at odds with the convention wisdom of some in finance who believe you have to be in the market during risky periods like a recession to gain extra return. You get paid to take risk during periods like a recession. This new research says that it does not matter when you invest in the business cycle. Managing risk will improve performance and that means cutting exposure when volatility is high. Timing market volatility will help with any investment strategy because volatility is generally independent of return. Put differently, if you control the risk, you will be better off versus a simple buy and hold for a given factor exposure. 

This is all explained clearly in the paper "Volatility Managed Portfolios" by Alan Moreira and Tyler Muir. Their approach to volatility management is very straightforward which make their conclusions so powerful. The authors scale exposure by the inverse of conditional volatility while focusing on the classic Fama-French factors and carry. Since volatility is persistent, variable, but not highly predictive of excess returns, managing or timing risk is not closely associated with the factors driving returns. 

The importance of this paper is evident once it is read in its entirety. The authors carefully address many of the concerns that reader may have and test the hypothesis from a number of different perspectives. While the enhancement from volatility management is not strong in all cases, the weight of the evidence suggests that volatility management is a key way for managers to enhance return to risk.

The real market skill for many managers may be with their timing of volatility and not returns. Cutting (raising) exposure at higher (lower) volatility periods seems to be a proven strategy for alpha generation and Sharpe ratio increases. This research provides support for a comment that I have often used, "I would only charge 75bps for a simple trend-following model but 125 bps and  a 20% incentive fee for the risk management." 

(Hat tip to Peter Golger for pointing me to this paper.)

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