Do strategies that seek to exploit return volatility persistence by adjusting stock market exposure inversely with recent market volatility relative to some target (including exposures greater than 100%) produce obvious benefits for investors? In their November 2017 paper entitled “Tail Risk Mitigation with Managed Volatility Strategies”, Anna Dreyer and Stefan Hubrich examine usefulness of managing volatility in this way as applied to the S&P 500 Index over a long sample period and across a range of performance measurements. They use daily index returns in excess of the return on cash and rebalance stock index-cash test portfolios daily. Their target volatility is variable, set as the inception-to-date realized daily excess return volatility. They assess robustness across different sample subperiods, past volatility measurement intervals and portfolio holding intervals. They measure portfolio performance conventionally (Sharpe ratio), via effects on portfolio return distribution skewness and kurtosis (as an indicator of tail risk) and with investor utility metrics. Using daily excess returns for the S&P 500 Index during July 1926 through November 2016, they find that:
- Over the full sample period, the correlation of returns between adjacent 60 trading day intervals is near zero. However, the correlation of daily return standard deviations is 0.55 (volatility is persistent and therefore predictable).
- Managing volatility offers only modest gross Sharpe ratio improvement on average, and improvement concentrates among: (1) certain subperiods, (2) short volatility measurement intervals and (3) holding intervals less than one quarter.
- For the subperiod since 1960, managing volatility does not materially improve gross Sharpe ratio. For the subperiod since 1990, managing volatility boosts gross Sharpe ratio by 5%-10%.
- For long holding intervals, managing volatility may lower Sharpe ratio.
- Managing volatility tends to normalize index excess returns by suppressing kurtosis and increasing skewness for monthly and quarterly holding periods. For long holding intervals, index excess return kurtosis is close to normal, and managing volatility has little effect on kurtosis.
- The normalizing effects of managed volatility improve investor utility robustly across most subperiods and holding intervals, with improvement decreasing as holding period increases and as level of investor risk aversion increases. For example, using the full sample and a conventional level of risk aversion, managed volatility has an annual value of 0.76% (0.31%) for an investor with investment horizon one month (three years).
- Daily volatility management induces considerable portfolio turnover. Assuming implementation via S&P 500 Index futures with 0.03% bid-ask spread (but ignoring roll return, margin requirements and collateral management) results in 0.42% annual trading frictions. Imposing trading volume constraints reduces frictions to 0.32%.
In summary, evidence indicates that a managed volatility strategy applied to the S&P 500 Index improves excess return per unit of tail risk compared to buy-and-hold, and has greater utility than buy-and-hold for some investors.
Cautions regarding findings include:
- Sharpe ratio analyses are gross, not net. Accounting for the costs of daily portfolio adjustments, including excess cost of leverage as specified (when recent actual volatility is low), would reduce the performance of managed volatility.
- Portfolio maintenance frictions for investor utility calculations do not account for all costs and assume implementation via index futures that are not available for much of the sample period.
- The strategy does not address treatment of dividends. In general, ignoring dividends gives an advantage to market timing over buy-and-hold.
- As noted in the paper, subperiod analyses involve a return standardization step that incorporates look-ahead bias.
- Results may differ for markets other than that represented by the S&P 500 Index.
- Volatility managed daily is beyond the reach of many investors, who would bear fees for delegating execution to a fund manager.
