Volatility Timing: Does It Work?

Volatility of an asset is the measure of how much its price changes over time. The higher the volatility, the greater the price swings. There are two types of volatility: historical and implied. Historical volatility is a measure of how much an asset’s price has fluctuated in the past. Implied volatility is a measure of how much the markets expect it to fluctuate in the future.

Volatility is important because it can have a big impact on the value of your investments. For example, if you’re holding an asset that has high volatility, the value of your investment will be more volatile as well.

Reference [1] proposed a volatility timing technique to manage an investment portfolio. It pointed out,

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Volatility-managed portfolios offer large risk-adjusted returns and are easy to implement in real time. Because volatility does not strongly forecast future returns, factor Sharpe ratios are improved by lowering risk exposure when volatility is high and increasing risk exposure when volatility is low. Our strategy runs contrary to conventional wisdom because it takes relatively less risk in recessions and crises yet still earns high average returns. We analyze both portfolio choice and general equilibrium implications of our findings. We find utility gains from volatility timing for mean-variance investors of around 65%, which is much larger than utility gains from timing expected returns. Furthermore, we show that our strategy performance is informative about the dynamics of effective risk-aversion, a key object for theories of time-varying risk premia.

Basically, the authors advocated lowering risk exposure when volatility is high and increasing risk exposure when volatility is low.

The results are counterintuitive. When volatility is high, one would expect it to revert to the mean, i.e. the market to recover. Consequently, investors would need to increase their equity exposure.

We will test this hypothesis to draw our own conclusion. At this stage, however, we agree with the authors that volatility is an important market regime filter.

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

References

[1] Moreira, Alan and Muir, Tyler, Volatility-Managed Portfolios (2016), https://ssrn.com/abstract=2659431