Managing portfolios using volatility as a filter has proven effective. Reference [1] builds on this research by proposing the use of volatility of volatility for portfolio management. The rationale behind using volatility of volatility is that it represents uncertainty.
Unlike risk, which refers to situations where future returns are unknown but follow a known distribution, uncertainty means that both the outcome and the distribution are unknown. Stocks may exhibit uncertainty when volatility or other return distribution characteristics vary unpredictably over time.
Practically, the author used a stock’s daily high and low prices to derive its volatility of volatility. They pointed out,
Specifically, we hypothesise that the benefits of volatility management are more pronounced for low uncertainty stocks and during periods of low aggregate uncertainty. To test these hypotheses, we use a measure of uncertainty based on the realised volatility-of-volatility (vol-of-vol) derived from intraday high and low prices. We first examine the relation between this measure of uncertainty and future returns. Consistent with the extant literature, we find that uncertainty is positively related to returns, and that it contains unique information about future returns not captured by other stock characteristics. We then explore the role of uncertainty in the performance of volatility management, across individual stocks and over time. We show that volatility management yields a significantly larger improvement in risk-adjusted performance for stocks with low uncertainty compared to those with high uncertainty and, for the market portfolio, it yields better performance during periods of low aggregate uncertainty compared to periods of high uncertainty. We also show that uncertainty potentially explains the performance of volatility management when applied to different asset pricing factor portfolios. Furthermore, our findings complement the sentiment-driven explanation of Barroso and Detzel (2021), revealing that the effect of sentiment on volatility management crucially depends on the level of uncertainty.
In short, using the volatility of volatility as a filter proves to be effective, particularly for low-uncertainty stocks.
We find it insightful that the author distinguishes between risk and uncertainty and utilizes the volatility of volatility to represent uncertainty.
Let us know what you think in the comments below or in the discussion forum.
References
[1] Harris, Richard D. F. and Li, Nan and Taylor, Nicholas, The Impact of Uncertainty on Volatility-Managed Investment Strategies (2024). https://ssrn.com/abstract=4951893
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