Enhancing Volatility Portfolio Returns with VRP Timing

The volatility risk premium (VRP) refers to the compensation investors receive for bearing the risk of higher-than-expected market volatility, often manifesting as the difference between implied and realized volatility in options markets. The VRP is not constant; it changes according to the market regime.

Reference [1] proposed a timing scheme based on the idea that an increase in market volatility is typically associated with a statistically significant decrease in the conditional one-month VRP. It utilizes the inverse of realized volatility, the VIX, and GARCH(1,1) volatility to determine position sizes for volatility portfolios. These portfolios include variance swaps, VIX futures, and S&P 500 straddles. The authors pointed out,

We develop timing strategies for the VRP that are analogous to equity premium timing strategies based on realized volatility, as in Moreira and Muir (2017). These strategies involve trading two assets: a variance asset and a risk-free asset. To begin, we examine a benchmark portfolio with a fixed weight on the variance asset each month. While this simple strategy already delivers remarkable long-term returns, we show that the portfolio’s performance can be significantly enhanced by incorporating various timing factors, including several volatility measures and an ex-ante VRP measure. We find the simple volatility-managed strategies are particularly effective and robust. Our findings remain robust in both older and recent times and across three variance assets: variance swaps, VIX futures, and S&P 500 straddles. Our findings are unlikely affected by bid-ask spreads and hold after accounting for margin requirements.

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Our portfolios improve performance by reducing negative exposure to the variance assets once observing an increase in volatility. Essentially, we exploit the puzzle of the negative volatility-VRP relationship, which has been highlighted in several previous studies such as Cheng (2019). Notably, we find that, ex-post, various timing portfolios generate positive alpha and help reduce beta/exposure to constant-weight variance asset portfolio returns almost only during high-volatility regimes, not in low-volatility regimes…

In short, using realized volatility, the VIX, and GARCH(1,1) improves the risk-adjusted returns of volatility portfolios.

A counterintuitive argument used in this research is that when volatility is high, the VRP decreases. One would assume that when volatility increases, investors would increase the size of a short volatility position.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Aoxiang Yang, Volatility-Managed Volatility Trading, 2024, papers.ssrn.com/sol3/papers.cfm?abstract_id=4761614