Portfolio Volatility Research Articles

Practical Applications of The Death of Diversification Has Been Greatly Exaggerated

Large institutions have been gravitating toward factor-based asset allocation as an alternative to traditional asset class diversification in the wake of the global financial crisis of 2007–2009. In <b><i>The Death of Diversification Has Been Greatly Exaggerated</i></b>, <b>Antti Ilmanen</b> and <b>Jared Kizer</b> make the case that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than asset class diversification. Their award-winning article was published in the Spring 2012 issue of <b><i>The Journal of Portfolio Management</i></b>. It was awarded Best Article in the 14th Annual <b>Bernstein Fabozzi/Jacobs Levy Awards</b>. Ilmanen is a Managing Director at <b>AQR Capital Management</b> in London. Kizer is Director of Investment Strategy at Buckingham Asset Management in St. Louis. This <b><i>Practical Applications</i></b> report outlines the six strategies that were identified in the research and that have generated excess returns over the long term. “The factors are systemic rule-based strategies that have actually generated returns above the risk-free rate,” Kizer tells us in an interview.

Risk Dispersion Tool and Strategies - Peak Catastrophe Event Correlation and Variance Swaps

The growth of risk capital regulatory regimes and continuous convergence of re/insurance and capital markets instruments and investment processes creates demand for quantitative and systematic risk management strategies for portfolio and line-of-business volatility and correlation dispersion. From an active risk management and capital investment perspective portfolio volatility - variance of losses could be an asset. Markets are not efficient when determining volatility. Portfolio loss correlations could also be viewed as an asset as well as a risk factor; and need to be managed as both. Volatility – variance and correlation swaps are two well-developed vehicles for such purposes. In a first of a small series of technical articles we review definitions, component computation, and structuring of correlation and variance swaps for a re/insurance portfolio

Long-Only Momentum, Currency Hedging and Transaction Costs: Implications for a Swiss Equity Investor

This study investigates the efficiency of European capital markets by examining the profitability of four long-only momentum strategies, after transaction costs of 0.5%, from the perspective of a Swiss equity investor. The investment universe considered in this study includes securities denominated in CHF, EUR, and GBP. In a first step, momentum strategies are evaluated over a period of fifteen years without hedging exchange rate risk of EUR and GBP. In a second step, the performance of full- and optimal currency hedging strategies is assessed. Results show that momentum strategies, after having considered transaction costs, do not significantly outperform a simple buy-and-hold strategy in risk-adjusted terms. Nevertheless, currency hedging strategies do significantly reduce the return volatility of portfolios.

Risk spillovers in international equity portfolios

Abstract We define risk spillover as the dependence of a given asset variance on the past covariances and variances of other assets. Building on this idea, we propose the use of a highly flexible and tractable model to forecast the volatility of an international equity portfolio. According to the risk management strategy proposed, portfolio risk is seen as a specific combination of daily realized variances and covariances extracted from a high frequency dataset, which includes equities and currencies. In this framework, we focus on the risk spillovers across equities within the same sector (sector spillover), and from currencies to international equities (currency spillover). We compare these specific risk spillovers to a more general framework (full spillover) whereby we allow for lagged dependence across all variances and covariances. The forecasting analysis shows that considering only sector- and currency-risk spillovers, rather than full spillovers, improves performance, both in economic and statistical terms.

Summaries of Papers in this Issue

Summaries of Papers in this Issue

Does Presenting Investment Results Asset by Asset Lower Risk Taking?

We examine how the presentation of investment results affects risk taking using an experiment in which participants view results either asset by asset or aggregated into a portfolio result. Our experiment examines the investment choices of a nationwide sample of 249 participants in a simulation of investing for retirement. Segregating investment results by asset decreases subsequent risk taking. Those presented segregated results lower their equity proportion by 4.21% and their portfolio volatility by 0.88%. Both decreases are 8% of the mean levels of risk taking, 50.59% and 10.85%, respectively. At the beginning of the simulation, we present historical results of the investment options either asset by asset or aggregated into portfolios. Among the small number of participants who spend a significant amount of time studying these historic results, segregating results lowers their equity proportion by 9.81%. Our results are a challenge to fully rational theories of investment choice but are consistent with a combination of three aspects of prospect theory based models: loss aversion, narrow framing of individual-asset results, and diminishing sensitivity to aggregated gains and losses. Our experiment never varies the presentation of investment results across time, thus our results are distinct from the effect of myopic loss aversion.

Portfolio Volatility of Islamic and Conventional Stock: The Case of Indonesia Stock Market

Conventional finance suggests that the higher the risk of an investment, the higher the return it should give. Nevertheless, whether Islamic stocks that offer alternative investment in the stock market suggest different risk-return relationship still needs to be investigated. This empirical study is aimed at assessing risk-return behavior of Islamic stocks. This study employs cross sectional data of portfolio developed using beta-rank and market capitalization, in which daily data will better reflect the real volatility. This study also measures volatility of both conventional and Islamic stocks using Value-at-Risk (VaR). To check whether Islamic stocks are immune from any impact of financial crisis, this study utilizes three periods of observation, i.e., before, during and after the 2008 crisis. This study assesses risk and return using Multi-index model, in which variables tested are the respective fundamental factors. Results of this study will provide more accurate approach in Islamic stocks analysis.

Asset-Pricing Implications of Dividend Volatility

This paper establishes dividend volatility as a fundamental risk metric that prices assets. We theoretically incorporate dividend volatility clustering into a model in which narrow-framing investors are loss averse over fluctuations in the value of their investments. Our model shows that dividend volatility positively predicts future asset returns, with the predictive power increasing with the forecasting horizon; our model also sheds light on a variety of other asset-pricing phenomena. We further provide supporting empirical evidence that dividend volatility is indeed priced in the data. More specifically, aggregate dividend volatility predicts and is predicted by aggregate price-to-dividend ratios; aggregate dividend volatility predicts future aggregate market returns; and dividend volatility of portfolios sorted by size, book-to-market ratios, and past returns predicts future portfolio-level returns, respectively. This paper was accepted by Wei Xiong, finance.

Portfolio risk forecasting

This paper focuses on portfolio risk forecasting in an asymmetric framework. Risk is defined by two factors: the dependence structure and the volatility. In order to account for asymmetric dependencies, the return series' interdependence is estimated via a copula approach rather than the correlation matrix. This allows us to capture tightening dependence during periods of market turmoil and loose dependence during positive markets. In order to account for heteroscedasticity, volatility levels are forecasted via an EGARCH model. The combination of both methodologies allows precise estimates of the return series' joint distribution and their joint risk, respectively. Statistical analyses find that this model quantifies the distribution tails very accurately, resulting in precise value-at-risk estimates. We also construct minimum-risk portfolios on the basis of the volatility forecasts. The allocation procedures shift the portfolio shares according to predicted volatility levels. We find very low portfolio volatility levels and small downside risks, which emphasize the accuracy of our model's volatility forecasts.

On the Commonality of Characteristics of Managed Volatility Portfolios

This article investigates the commonality in risk factors and sector biases in managed volatility equity strategies (both active and passive). A unique aspect of this article is that it is written from the perspective of a user of the strategies. Unlike all other past studies it considerers several versions of low volatility strategies—from different managers with different investment approaches and risk models. The findings here are therefore more general and not specific to a particular implementation or risk model. We will explore both actively managed volatility strategies as well as an index strategy.

Idiosyncratic volatility and the pricing of poorly-diversified portfolios

This article examines the role of idiosyncratic volatility in explaining the cross-sectional variation of size- and value-sorted portfolio returns. We show that the premium for bearing idiosyncratic volatility varies inversely with the number of stocks included in the portfolios. This conclusion is robust within various multifactor models based on size, value, past performance, liquidity and total volatility and also holds within an ICAPM specification of the risk–return relationship. Our findings thus indicate that investors demand an additional return for bearing the idiosyncratic volatility of poorly-diversified portfolios.

How does oil market uncertainty interact with other markets? An empirical analysis of implied volatility index

OVX (Crude oil volatility index), as a measure of oil market uncertainty and new volatility derivatives published by CBOE (Chicago Board Options Exchange) during the 2008 global financial crisis, provides a direct prediction of the market's expectation for future 30-day crude oil price volatility. This paper investigates the short- and long-term cross-market uncertainty transmission implied by OVX and other important volatility indices which are VIX (stock market volatility index), EVZ (euro/dollar exchange rate volatility index) and GVZ (gold price volatility index). The results indicate that there are no strong long-run equilibrium relationships among these volatility indices, which indirectly verify the effectiveness of cross-market volatility portfolio strategy for risk hedge. Furthermore, OVX is significantly influenced by other ones, which indicates that investors' volatility expectation in the oil market become more sensitive to uncertainty shocks from other markets when the global economic situation is extremely unstable. Finally, impacts of interior and exterior uncertainty shocks on OVX are found to be positive and transient. And the significant short-term uncertainty transmission between oil and other major markets has been confirmed.

Zero-R2Hedge Funds and Market Neutrality

AbstractFactor models yield an R2 insignificantly different from 0 for one-third of hedge funds in a broad sample. These funds illustrate the concept of market neutrality and feature lower volatilities, higher Sharpe ratios, and higher alphas than other funds, indicating that they provide a successful alternative investment. However, large portfolios of zero-R2 funds contain fully half the volatility of portfolios of other funds, suggesting that they feature substantial systematic risk. Furthermore, these funds display an increased probability of failure even after controlling for idiosyncratic volatility. These results indicate the presence of an omitted factor that exposes investors to significant downside risk.

Reconciling Ex Post and Ex Ante Volatility Figures

Ex post volatility is defined as dispersion of ex post portfolio returns over the measurement period. Ex post volatility takes into account the variability in asset returns and changes of asset weights over time due to trading and drift. Ex ante volatility, on the other hand, is defined as forward-looking portfolio volatility calculated from current assets weights and asset covariance estimates. Except in very unrealistic circumstances, the two volatility measurements will typically differ. In this research note, we propose a Brinson-style attribution scheme that can be used to quantify the effects. Being able to attribute differences in ex ante and ex post volatilities to trading and risk surprises provides valuable information in investment process reviews for internal purposes as well as client communications.

Do High-Frequency Data Improve High-Dimensional Portfolio Allocations?

This paper addresses the open debate about the usefulness of high-frequency (HF) data in large-scale portfolio allocation. We consider the problem of constructing global minimum variance portfolios based on the constituents of the S&P 500 over a four-year period covering the 2008 financial crisis. HF-based covariance matrix predictions are obtained by applying a blocked realized kernel estimator, different smoothing windows, various regularization methods and two forecasting models. We show that HF-based predictions yield a significantly lower portfolio volatility than methods employing daily returns. Particularly during the volatile crisis period, these performance gains hold over longer horizons than previous studies have shown and translate into substantial utility gains from the perspective of an investor with pronounced risk aversion.

International Diversification During the Financial Crisis: A Blessing for Equity Investors?

This paper empirically investigates international equity investors’ foreign portfolios before and during the financial crisis by estimating a gravity model for 22 source and 42 destination countries. The results show that international stock market diversification provides large gains during the financial crisis. This is remarkable because of large stock market correlations. During the financial crisis investors have larger positions in foreign stock markets which are relatively less correlated with the domestic market. However, this relationship is not present before the crisis. Results at the country level show that aggregate portfolio volatility is lower and returns are higher for investors from low home biased source countries during the financial crisis. This result implies that global equity diversification has an important positive effect on stabilizing a country’s aggregate equity wealth, especially during periods of stock market stress.

The Low Risk Anomaly: A Decomposition into Micro and Macro Effects

Low beta stocks have offered a combination of low risk and high returns. We decompose the anomaly into micro and macro components. The micro component comes from the selection of low beta stocks. The macro component comes from the selection of low beta countries or industries. The two parts both contribute to the low beta anomaly, with important implications for the construction of managed volatility portfolios.

The 4 Percent Rule is Not Safe in a Low-Yield World

The safety of a 4% initial withdrawal strategy depends on asset return assumptions. Using historical averages to guide simulations for failure rates for retirees spending an inflation-adjusted 4% of retirement date assets over 30 years results in an estimated failure rate of about 6%. This modest projected failure rate rises sharply if real returns decline. As of January 2013, intermediate-term real interest rates are about 4% less than their historical average. Calibrating bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, causes the projected failure rate for retirement account withdrawals to jump to 57%. The 4% rule cannot be treated as a safe initial withdrawal rate in today’s low interest rate environment. Some planners may wish to assume that today’s low interest rates are an aberration and that higher real interest rates will return in the medium-term horizon. Although there is little evidence to support this assumption, we estimate how a reversion to historical real yields will impact failure rates. Because of sequence of returns risk, portfolio withdrawals can cause the events in early retirement to have a disproportionate effect on the sustainability of an income strategy. We simulate failure rates if today's bond rates return to their historical average after either 5 or 10 years and find that failure rates are much higher (18% and 32%, respectively for a 50% stock allocation) than many retirees may be willing to accept. The success of the 4% rule in the U.S. may be an historical anomaly, and clients may wish to consider their retirement income strategies more broadly than relying solely on systematic withdrawals from a volatile portfolio.

Did Long-Short Investors Destabilize Commodity Markets?

This paper contributes to the debate on the effects of the financialization of commodity futures markets by studying the conditional volatility of long-short commodity portfolios and their conditional correlations with traditional assets (stocks and bonds). Using several groups of trading strategies that hedge fund managers are known to implement, we show that long-short speculators do not cause changes in the volatilities of the portfolios they hold or changes in the conditional correlations between these portfolios and traditional assets. Thus calls for increased regulation of commodity money managers are, at this stage, premature. Additionally, long-short speculators can take comfort in knowing that their trades do not alter the risk and diversification properties of their portfolios.

Portfolio volatility of Islamic and conventional stock: The case of Indonesia stock market

Conventional finance suggests that the higher the risk of an investment, the higher the return it should give. Nevertheless, whether Islamic stocks that offer alternative investment in the stock market suggest different risk-return relationship still needs to be investigated. This empirical study is aimed at assessing risk-return behavior of Islamic stocks. This study employs cross sectional data of portfolio developed using beta-rank and market capitalization, in which daily data will better reflect the real volatility. This study also measures volatility of both conventional and Islamic stocks using Value-at-Risk (VaR). To check whether Islamic stocks are immune from any impact of financial crisis, this study utilizes three periods of observation, i.e., before, during and after the 2008 crisis. This study assesses risk and return using Multi-index model, in which variables tested are the respective fundamental factors. Results of this study will provide more accurate approach in Islamic stocks analysis.