This research shows that the horizon of these two variables – volatility and future return - behave quite differently. Volatility tends to spike and recede quickly, whereas expected returns are more persistent and realized in a slower manner with a longer horizon. An investor may miss the first leg of the future returns while volatility decreases/normalizes, but returns tend to remain persistent allowing the investor a chance to participate even as they enter with a delay. On a risk-adjusted basis, this reaction generates superior performance and better downside protection.
Trading Costs
When taking into account practical considerations such as transaction costs, Muir and Moreira’s findings still stand. A strategy that trades only when last month volatility is higher than the historical average generates an average monthly turnover of 10% and an annual outperformance of 2.2% before trading costs.
For this outperformance to vanish, the transaction costs will have to be 1.83%. Current reasonable estimates of transaction costs are 10-15bps of traded value in retail platforms and lower in institutional settings so investors get a big chunk of the outperformance.
Volatility Timing and Portfolio Holdings
How can advisors and investors utilize volatility timing? First, they need to have portfolios that are truly diversified. If you can’t predict which markets will be up or down, you need to be in many asset classes (including alternatives), sub asset classes, multiple economies and regions to achieve a better investment outcome. With the broad range of ETFs available today, a well-diversified portfolio can be constructed with 100% ETFs.
Second, is a careful, systematic review of the movement of portfolio positions and how each movement impacts other parts of the portfolio. Then you need to make changes accordingly and consistently.
Third, is applying volatility management. Essentially, when volatility goes up, this approach decreases the exposure to the volatile position. This may seem counterintuitive to those with a value mindset who won’t sell or panic, but rather buy.
However, reducing drawdown is as valuable as prognosticating about the upside. Why? Volatility and future return behave quite differently. Volatility tends to spike and recede quickly, whereas expected returns are more persistent and realized in a slower manner with a longer horizon. This means that an investor may miss the first leg of the future returns while volatility decreases/normalizes, but returns tend to remain persistent allowing the investor a chance to participate even as they enter with a delay. On a risk-adjusted basis, this reaction using volatility management typically generates superior performance and better downside protection.
Vinay Nair, Ph.D., is co-chairman of 55 Capital and a visiting professor at The Wharton School.