Bridge over ocean
4 September 2020 Financial Analysts Journal Volume 76, Issue 4

Conditional Volatility Targeting

  1. Dion Bongaerts
  2. Xiaowei Kang, CFA
  3. Mathijs A. van Dijk

By employing conditional volatility targeting strategies, investors can enhance returns while reducing the drawdown and turnover implied by the standard volatility targeting strategies.

In analyzing the performance of volatility-targeting strategies, we found that conventional volatility targeting fails to consistently improve performance in global equity markets and can lead to markedly greater drawdowns. Motivated by return patterns in various volatility states, we propose a strategy of conditional volatility targeting that adjusts risk exposures only in the extremes during high- and low-volatility states. This strategy consistently enhances Sharpe ratios and reduces drawdowns and tail risks, with low turnover and leverage, when used in the major equity markets and for momentum factors across regions. Conditional volatility management can also be applied to tactical allocations among multiple assets or risk factors.

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