Volatility targeting outperforms a buy and hold strategy, but why? Volatility targeting is the process of adjusting risk exposure or leverage to set a specific volatility level. Usually, managers set the leverage and allow the volatility to move.
Volatility targeting works because there is a negative correlation between return direction and volatility which has been called the leverage effect. Volatility targeting will be negatively related to the magnitude of recent returns. Given this relationship, we can say that volatility targeting has a trend following effect. The relationship between volatility targeting and trend-following was explored more closely in recent research paper, see "Volatility Targeting is Trendy: How Trend Following Explains alpha in Volatility-Managed Strategies". The leverage effect is not present with bonds, commodity and currencies. If you control for trend-following the alpha from volatility targeting will decline by about 2/3rds when tested against a portfolio of 14 stock indices. The volatility targeting link to trend-following does not occur with other asset classes.
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