The Impact of Volatility Targeting
28 Pages Posted: 17 May 2018 Last revised: 11 Jul 2018
Date Written: June 25, 2018
Recent studies show that volatility-managed equity portfolios realize higher Sharpe ratios than portfolios with a constant notional exposure. We show that this result only holds for “risk assets”, such as equity and credit, and link this to the so-called leverage effect for those assets. In contrast, for bonds, currencies, and commodities the impact of volatility targeting on the Sharpe ratio is negligible. However, the impact of volatility targeting goes beyond the Sharpe ratio: it reduces the likelihood of extreme returns, across all asset classes. Particularly relevant for investors, “left-tail” events tend to be less severe, as they typically occur at times of elevated volatility, when a target-volatility portfolio has a relatively small notional exposure. We also consider the popular 60-40 equity-bond “balanced” portfolio and an equity-bond-credit-commodity “risk parity” portfolio. Volatility scaling at both the asset and portfolio level improves Sharpe ratios and reduces the likelihood of tail events.
Keywords: volatility, volatility targeting, balanced fund, risk parity, asset allocation, portfolio choice
JEL Classification: E32, E44, G11, G12, G15, G17
Suggested Citation: Suggested Citation