Abstract
In analyzing the performance of volatility-targeting strategies, we found that conventional volatility targeting fails to consistently improve performance in global equity markets and can lead to markedly greater drawdowns. Motivated by return patterns in various volatility states, we propose a strategy of conditional volatility targeting that adjusts risk exposures only in the extremes during high- and low-volatility states. This strategy consistently enhances Sharpe ratios and reduces drawdowns and tail risks, with low turnover and leverage, when used in the major equity markets and for momentum factors across regions. Conditional volatility management can also be applied to tactical allocations among multiple assets or risk factors.
Highlights
In analyzing the performance of volatility-targeting strategies, we found that conventional volatility targeting fails to consistently improve performance in global equity markets and can lead to markedly greater drawdowns
Motivated by return patterns in various volatility states, we propose a strategy of conditional volatility targeting that adjusts risk exposures only in the extremes during high- and low-volatility states
We found that conventional volatility-targeting strategies fail to consistently enhance risk-adjusted performance in global equity markets and can lead to markedly greater drawdowns than without volatility targeting
Summary
We review the performance drivers of volatility targeting, consider the challenges of implementing the conventional strategy, and discuss motivation for the conditional strategy. Consistent with our findings for the US factors and with a concurrent paper by Cederburg, O’Doherty, Wang, and Yan (forthcoming), the conventional strategy improved Sharpe ratios and reduced downside risk for the momentum factor in various regions but did not do so for other factors.16 This finding is in contrast to Moreira and Muir (2017), who found that volatility-managed portfolios produce large alphas for all equity factors. This relationship explains the relatively weak and inconsistent performance of conventional strategies in global markets.
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