In part two of our series on risk management strategies, we discussed the risk parity approach in detail and analysed how you can protect your portfolio during volatile markets. In this article, we `have a closer look at the target volatility approach - a strategy aiming for constant volatility.
Why You Should Care About Volatility
When asked about their asset allocation, most investors will probably follow a set target (e.g. 60/40), with their portfolios routinely rebalanced to meet it. The problem with this approach is that it implies constant risk for each asset class. As a consequence, most portfolios are nowadays based on the false assumption that the volatility for each asset class remains stable. The reality, though, is very different. In fact, volatility is very volatile in itself. Take the S&P 500 Index; its volatility has averaged 13.9% since 1950, but has ranged between 5.3% and 39.4% along the way.
Volatility picks up especially during tail events. If investors rebalance their portfolios to its starting allocation when volatility spikes, they would in effect increase the portfolios’ overall risk. Or to put it differently: whenever volatility rises, i.e. the stock market falls, investors would sell the less risky assets and buy the riskier ones.
On that basis, it seems clear that a portfolio built on a constant asset allocation target will not be well diversified over time. Therefore, it would make sense to manage it by targeting constant volatility instead.
How To Manage Volatility
“Past performance is not a predictor for future returns” should be a familiar sentence to most investors. However, it’s a different story when it comes to risk, as past volatility is a much better predictor of future volatility.
What follows is a sample portfolio example that targets constant volatility. These days, there are many simple models to estimate volatility, from simple risk models, to those using implied volatility in options or just using historical data. For our purposes, we estimated the volatility of each asset class based on historical data.
For our sample portfolio, we used the historical 3-month trailing volatility of the MSCI World Index and the Barclays Global Aggregate Index while targeting a future 3-month volatility of 10%. To estimate the volatility for our stocks and bonds allocation, we assumed that the volatility over the last three months will persist over the next trailing 3 month period. Also, because in some high volatile markets it was not possible to create a long-only portfolio with a target volatility of 10% using our estimation model, we targeted a slightly higher volatility in these markets to avoid going short in any asset class.
The following graph compares our target volatility portfolio with a simple 60/40 portfolio that rebalances annually. The comparative analysis shows that the target volatility portfolio outperformed the 60/40 portfolio over the full period going back to 1991.
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The curious reader will probably question if this strategy doesn’t effectively mean “selling low and buying high”, as the asset class with rising volatility would be sold and the one with falling volatility would be bought. This is partly true, but would miss one important point: the risk-adjusted stock returns do remain the same during rising volatility. By contrast, investors pursuing a static asset allocation in volatile markets would increase their risk allocation to asset classes with equal or lower risk-adjusted returns – not a desirable investment strategy. A study done by AQR Capital Management suggests that portfolios with a stable risk allocation and a high estimated volatility can yield higher risk-adjusted returns. In sum, rather than assuming the extra cost of buying insurance, a volatility-management strategy can reduce tail risks while maintaining the odds of outperformance.
In the next part of our series, we will analyse a low beta strategy – an approach that aims to invest in defensive stocks which tend to trail both in up and down markets. Low beta stocks generate outperformance over the long run.
Investors interested in an in-depth explanation of volatility should have a look at our article “Volatility: A Sophisticated and Potentially Pricey Portfolio Tool”.
