Conditional Volatility Targeting (Summary)

Investment managers have used volatility targeting to dynamically adjust market exposure and improve performance. However, conventional volatility targeting generates high turnover and has failed to consistently enhance risk-adjusted equity performance.

This article proposes a volatility targeting strategy that adjusts risk exposures only during periods of extreme high and low volatility, which produces better risk-adjusted performance and reduces costs.

This conditional strategy uses equity index futures and investable equity factors, which can be relatively easily implemented and for which transaction costs are visible and manageable.

The authors create an enhanced volatility targeting strategy based on the finding that during times of high volatility, volatility clustering is stronger, so the correlation between volatility and future returns is strongly negative.

The conditional volatility targeting strategy reduces exposure to a chosen asset class in times of high volatility and increases exposure when volatility is low. For both equity markets and equity factors, the authors assess the long-term (at least 10 years) of each asset to avoid the look-ahead bias found in conventional strategies.

The conditional strategy is applied to each of the following: global equity markets, US equity factors, and global momentum factors.

The authors find that when conventional volatility targeting is applied to equities, the Sharpe ratio is increased for momentum strategies but not for the size, value, profitability, and investment factors. Conventional volatility strategies also have high portfolio turnover and significant leverage and tend to overshoot their volatility targets.

The conditional volatility targeting strategy consistently enhances Sharpe ratios and reduces drawdowns and tail risks in major equity markets and factors across regions. It has lower turnover and leverage than conventional volatility strategies.

The conditional strategy reduces the maximum drawdown across all equity markets by an average of 6.6%. In comparison, conventional volatility targeting strategies actually increase the maximum drawdown in the United Kingdom, Canada, Australia, and Hong Kong, SAR.

The conditional volatility targeting strategy improves Sharpe ratios across all markets, while the conventional strategy improves the Sharpe ratio in just 8 out of 10 markets. This performance is robust across different markets.

Applied to investment factors, the conditional strategy enhances Sharpe ratios substantially for momentum factors and to a lesser degree for other factors. The conditional strategy more than doubles the Sharpe ratio for momentum and reduces maximum drawdowns from 54.1% to 20.1%.

The annual turnover of the conditional strategy is 1.4 across all markets, compared with 2.1 for the conventional strategy, a significant reduction. Finally, the conditional strategy has a realized volatility much closer to the markets to which it is applied. By comparison, conventional volatility strategies tend to have a systematic bias to over- or undershoot their volatility targets.

Against a backdrop of modest expected returns and high uncertainty in global equity markets, the conditional volatility targeting strategy can be used to enhance the risk-adjusted performance of broad equity markets.

The strategy is particularly beneficial for momentum factor returns, which have been modest, with sizable volatility and drawdowns in recent decades.