Volatility-Managed Portfolios
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What they found
The authors tested a simple rule: scale your exposure to a strategy by the inverse of its recent realized variance, reducing size when volatility has been high and increasing it when volatility has been low. Applied to the market portfolio and to the standard factors (value, momentum, profitability, betting against beta, currency carry) from 1926 to 2015, the rule raised Sharpe ratios substantially and produced large alphas relative to the unmanaged versions. The reason is that volatility is highly persistent but its relationship with expected returns is weak, so high-volatility periods have a worse risk-return trade-off.
What you can use
- Cutting position size when recent volatility spikes and adding when it is calm has historically improved risk-adjusted returns across nearly every strategy.
- The trade-off works because volatility is predictable but returns after volatility spikes are not higher on average.
- Volatility targeting is one of the few adjustments that helps momentum, value, carry, and the market index alike.
Caveats
Requires leverage in calm periods to achieve the gains, and Cederburg and coauthors (2020) show the improvement is unreliable out of sample for many factors and disappears with realistic constraints. Turnover can be high.
Tags: volatility, volatility-targeting, position-sizing, factor
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.