Volatility‐Managed Portfolios

Abstract

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

On Industry Momentum Strategies

“…Additionally, as first proposed by Barroso and Santa‐Clara () and Moreira and Muir (), we use a simple risk estimate of the 1–0–1 strategy to scale the exposure to constant risk over time. For each month t , the variance forecasts are computed from daily returns in the previous month.…”

“…However, the correlations between this proposed strategy and traditional industry momentum strategies are low, which is further supported by principal component analysis. Further analyses reveal that risk managing the zero-cost strategy in the spirit of Moreira and Muir (2017) adds value and substantially increases the Sharpe ratio. This finding supports that of Grobys, Ruotsalainen, and Äijö (2018) and Grobys (2018), who similarly document higher Sharpe ratios for risk-managed industry momentum strategies.…”

When fund management skill is more valuable?

“…For example,Moreira and Muir (2016) showed that a volatility-managed portfolio, which decreases portfolio volatility when the expected market risk is high and increases the portfolio volatility when expected market risk is low, yields high alphas and increases the portfolio Sharpe ratio significantly.…”

The Performance of Market‐Timing Strategies of Italian Mutual Fund Investors

“…Note that markettiming strategies are not necessarily doomed to fail and do not necessarily depend on a return chasing motif. In fact, according to the recent empirical and theoretical literature, if returns are somewhat predictable, then investors may be able to achieve higher Sharpe ratios by timing the market [see, Gallant et al (1990), Brandt (1999), Campbell and Viceira (2002) and Cochrane (2011)], for example, as a function of the current price to dividend ratio or market volatility (Moreira and Muir, 2017). Therefore, a priori, we cannot say if investors could do better than simply holding the market.…”