Alpha Generation and Risk Smoothing Using Managed Volatility

Abstract

It is difficult to predict stock market returns but relatively easy to predict market volatility. But volatility predictions don't easily translate into return predictions since the two are largely uncorrelated. We put forward a framework that produces a formula in which returns become a function of volatility and therefore become somewhat more predictable. We show that this strategy produces excess returns giving us the upside of leverage without the downside.

As a side-effect the strategy also smooths out volatility variation over time, reduces the kurtosis of daily returns, reduces maximum drawdown, and gives us a dynamic timing signal for tilting asset allocations between conservative and aggressive assets.

It has been said that diversification is the only free lunch in investing. It appears that once you have diversified away some risk you can get a further free lunch by smoothing what risk remains.

Keywords: volatility timing, volatility of volatility, extreme volatility, volatility drag, managed volatility, continuously dynamic leverage, leveraged exchange traded funds, alpha generation, kurtosis, maximum drawdown

JEL Classification: C22, C5, G1