Skip to content
All library documents

Volatility Timing Through Inverse-Volatility Exposure

Article Quant Q&A · Author: Skills
Read the original

Summary

Volatility timing adjusts exposure to risky assets according to recent or current volatility. The basic approach reduces exposure when measured volatility is high and increases it when volatility is low; the document notes that this can mean cutting risk during market panics and adding it again as volatility subsides. Portfolio weights may be scaled inversely with volatility.

The document cites research reporting improved gross risk-adjusted performance for volatility-managed portfolios across equity factors and currency carry, attributing the effect to expected returns not changing in proportion to volatility. It also presents the strategy as a retrospective finding that warrants skepticism: performance observed in past crises may not persist. The discussion gives no implementation details, estimation choices, transaction-cost analysis, or out-of-sample validation, so it does not establish that volatility timing will work for a particular portfolio.

Key ideas

  • Volatility timing changes risky-asset exposure in response to measured volatility.
  • Inverse-volatility weighting reduces exposure when volatility rises and increases it when volatility falls.
  • Cited research reports higher risk-adjusted performance across equity factors and currency carry.
  • The reported historical findings may not persist and do not guarantee future performance.

Tags

VolatilityRisk managementPortfolio constructionFactor investing
Full text
# What's volatility timing?


# What's volatility timing?












I'm new and i'm starting studying finance. My english level is not so good. Could you explain me please, what is volatility timing?

Thanks to all

## Answer by vonjd (score 4)

https://quant.stackexchange.com/a/37377

Volatility timing lowers exposure to risky assets when volatility of recent returns for those assets is relatively high and raises exposure to risky assets when volatility of recent returns for those assets is relatively low. Contrary to conventional wisdom, this volatility-managed strategy e.g. sells during panics like the Great Depression and 2008.

Evidence indicates that weighting investments in risky asset portfolios by inverse volatility may enhance gross risk-adjusted performance (already mentioned in the comments by @noob2):

Moreira, Alan and Muir, Tyler, Volatility-Managed Portfolios (October 25, 2016). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2659431 or http://dx.doi.org/10.2139/ssrn.2659431

Abstract

> Managed portfolios that take less risk when volatility is high produce large alphas, substantially increase factor Sharpe ratios, and produce large utility gains for mean-variance investors. We document this for the market, value, momentum, profitability, return on equity, and investment factors in equities, as well as the currency carry trade. Volatility timing increases Sharpe ratios because changes in factors' volatilities are not fully offset by proportional changes in expected returns. Our strategy is contrary to conventional wisdom because it takes relatively less risk in recessions and crises yet still earns high average returns. This rules out typical risk-based explanations and is a challenge to structural models of time-varying expected returns.

Summary (behind paywall): https://www.cxoadvisory.com/28346/volatility-effects/varying-risk-inversely-with-recentexpected-volatility/

## Answer by nbbo2 (score 3)

https://quant.stackexchange.com/a/37379

Broadly speaking "volatility timing" means adjusting your portfolio based on current (implied or historical) volatility.

This is a relatively new area of research, which developed a few years after the financial crisis when researchers discovered that reducing exposure during the crisis in response to increased volatility (and increasing it later as volatility calmed down) would have produced good results. Like all retrospective findings (or as my boss calls them "telling me today what I should have done yesterday" or "driving by looking in the rear view mirror") we should be a little skeptical whether it will produce equally good results in the future. Nevertheless it is an interesting area that has been fashionable and I recommend the three best papers in my opinion:

Moreira and Muir: Volatility-Managed Portfolios (2015) SSRN 2659431

Hallerbach: Advances in Portfolio Risk Control (2013) SSRN 2259041

Cooper: Alpha Generation and Risk Smoothing Using Managed Volatility (2010) SSRN 1664823

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.