Volatility Targeting for Long-Short Macro Momentum Portfolios
Summary
The document discusses a long-short macro momentum portfolio whose positions are adjusted so that the portfolio has a specified forecast volatility. The cited research describes estimating risk from a rolling window of monthly returns and scaling the resulting portfolio toward a target annual volatility. The answer relates this process to volatility targeting and risk parity, and notes that the risk adjustment can be applied around the construction of the underlying long and short weights.
The response gives conceptual context rather than a reproducible calculation: it does not specify the volatility estimator, the exact scaling rule, treatment of leverage, or portfolio constraints. It also points out that the source description does not reveal the full mathematics, so implementations cannot be inferred uniquely. The cited target and estimation horizon belong to the referenced strategy; the discussion does not present independent tests or evidence that volatility targeting improves returns. It is a useful introduction to portfolio risk scaling, with methodological details left open.
Key ideas
- Volatility targeting scales a portfolio’s exposure to bring forecast risk toward a chosen level.
- The described macro momentum strategy estimates risk from a rolling history of monthly portfolio returns.
- Risk scaling is an outer adjustment to the long-short portfolio’s weights.
- The response compares the idea with risk parity but does not provide a complete implementation.
- The choice of estimator, leverage limits, and other constraints remains unspecified.
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Full text
# Adjusting volatility while constructing portfolio # Adjusting volatility while constructing portfolio I am trying to construct a portfolio based on a macro momentum strategy for backtesting purposes as outlined in https://www.aqr.com/-/media/AQR/Documents/Insights/White-Papers/A-Half-Century-of-Macro-Momentum.pdf. So after constructing a long-short portfolio, the author outlines the following "I then volatility-adjust the resulting long and short positions such that the long-short portfolio is at 10% annual forecasted volatility using a three-year rolling risk model on monthly returns." I am not from a finance background so if someone can please explain what does that mean, it would be really helpful. Please see page 20 in the pdf for more details. If you think the question is badly framed then please suggest edits. Thanks. ## Answer by develarist (score 3) https://quant.stackexchange.com/a/49694 Page 6 also describes > Long-short portfolios take long (or short) positions in assets with favorable (or unfavorable) macroeconomic trends relative to the cross-sectional average, and are designed to be market neutral at all points in time. Combined with the quote you found, I think there is math behind his approach that isn't shared in the write-up, but sounds alot like the Risk Parity approach, especially Volatility Targeting portfolios, where the overall portfolio volatility is targeted to be some value (10%) for the chosen time horizon settings. Step-wise, targeting the overall portfolio volatility is usually a shell outside the actual estimation and transformation of individual portfolio weights. There is no math anywhere so it can be anyone's guess how the numbers are obtained. Besides the minimum variance and maximum diversification portfolios, other common portfolio risk optimization techniques include: - Risk parity portfolio > Maillard, S., T. Roncalli, andj. Teiletche. “The Properties of Equally Weighted Risk Contribution Portfolios.” The Journal of Portfolio Management, Vol. 36, No. 4 (2010), pp. 60-70. Chaves, D., J. Hsu, F. Li, and O. Shakernia. “Risk Parity Portfolio versus Other Asset Allocation Heuristic Portfolios.” The Journal of Investing, Vol. 20, No. 1 (2011), pp. 108-108. Asness, C., A. Frazzini, and L. Pedersen. “Leverage Aversion and Risk Parity.” Financial Analysts Journal, Vol. 68, No. 1 (2012), pp. 47-59. - Volatility targeting portfolio > Busse,J. “Volatility Timing in Mutual Funds: Evidence from Daily Returns.” Review of Financial Studies, Vol. 12, No. 5 (1999), pp. 1009-1041. Collie, R., M. Sylvanus, and M. Thomas. “Volatility- Responsive Asset Allocation.” White paper, Russell Investments, 2011. Butler, A., and M. Philbrick. “Volatility Management for Better Absolute and Risk-Adjusted Performance.” White paper, Macquarie Private Wealth Inc., 2012. Albeverio, S., V. Steblovskaya, and K. Wallbaum. “Investment Instruments With Volatility Target Mechanism.” Quantitative Finance, Vol. 13, No. 10 (2013), pp. 1519-1528.
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