One of the key features of volatility is that it is persistent, or “clusters”. High volatility over the recent past tends to be followed by high volatility in the near future. This observation underpins Engle’s (1982) pioneering work on ARCH models.1 In this paper, we study the risk and return characteristics of assets and portfolios that are designed to counter the fluctuations in volatility. We achieve this by leveraging the portfolio at times of low volatility, and scaling down at times of high volatility. Effectively the portfolio is targeting a constant level of volatility, rather than a constant level of notional exposure. Conditioning portfolio choice on volatility has attracted considerable recent attention. The financial media has zoomed in on the increasing popularity of risk parity funds.2 In recent work, Moreira and Muir (2017) find that volatility-managed portfolios increase the Sharpe ratios in the case of the broad equity market and a number of dynamic, mostly long-short stock strategies.
While most of the research has concentrated on equity markets, we investigate the impact of volatility targeting across more than 60 assets, with daily data from 1926. We find that Sharpe ratios are higher with volatility scaling for risk assets (equities and credit), as well as for portfolios that have a substantial allocation to these risk assets, such as a balanced (60-40 equity-bond) portfolio and a risk parity (equity-bond-credit-commodity) portfolio. Risk assets exhibit a so-called leverage effect, i.e., a negative relation between returns and volatility, and so volatility scaling effectively introduces some short-term momentum into strategies. Historically such a short-term trend strategy has performed well; see e.g. Hamill, Rattray, and Van Hemert (2016). For other assets, such as bonds, currencies, and commodities, volatility scaling has a negligible effect on realized Sharpe ratios.
We also show that volatility targeting can consistently reduce the likelihood of extreme returns (and the volatility of volatility) across our 60+ assets. Under reasonable investor preferences, a thinner left tail is much preferred (for a given Sharpe ratio).3 Volatility targeting reduces the maximum drawdowns for both the balanced and risk parity portfolio.
The outline of this paper is as follows. In Section 1, we discuss the data, volatility-scaling methods, and statistics used for comparing the performance of unscaled and volatility-scaled portfolios. In Section 2, we focus on US equities, for which we have data starting in 1926. In Section 3 we study US bonds and credit, and in Section 4 we look at 50 global equity indices, fixed income, currency, and commodity futures and forwards. The analyses for the multi-asset balanced and risk parity portfolios are covered in Section 5. In Section 6, we discuss the leverage effect to provide further insights as to why the Sharpe ratio of risk assets is improved by volatility scaling. We offer some concluding remarks in the final section and comment on methods other than volatility scaling that may improve the Sharpe ratio and left-tail risk of a long-only portfolio.
1. ARCH is autoregressive conditional heteroscedasticity. Robert Engle shared the 2003 Nobel Prize in Economics “for methods of analyzing economic time series with time-varying volatility (ARCH)” (https://www.nobelprize.org).
2 See e.g. the August 6, 2017 Wall Street Journal article “What is risk parity?”, https://www.wsj.com/articles/what-is-risk-parity-1502071260.
3 Under the common assumption of a concave utility function, and for a given Sharpe ratio, also a thinner right tail is preferred. A thinner left tail is more relevant though, as large negative returns have a disproportionately large effect on an investor’s utility.