Portfolio management with targeted constant market volatility

Abstract

Managing equity volatility exposure is fundamental to fund managers, insurance companies and pension funds. This is especially important for product developments including target-date portfolios and variable annuities where volatility management is critical. Empirical evidence shows asymmetry between equity market return and volatility, with returns and conditional volatility negatively correlated. We develop an approach that targets constant volatility in equity market portfolios and assess its performance with U.S., U.K., German and Australian data focusing on long term accumulation investment strategies popular with DC pension plans. Our approach to volatility management is univariate, in contrast to most of the existing approaches in the literature that are multivariate and more complex. Of particular relevance to pension funds is that we show substantial risk adjusted outperformance (in the range of an additional 100 to 350 basis points on average) relative to stock market index benchmarks, after transaction costs. Other features of the targeted constant volatility portfolios, relevant to insurers and pension funds, are a significantly reduced exposure to stock market crashes and low transaction costs relative to other approaches.