Volatility Timing under Low-Volatility Strategy

Abstract

We show that the slope of the volatility decile portfolio's return profile contains valuable information that can be used to time volatility under different market conditions. During good (bad) market condition, the high- (low-) volatility portfolio produces the highest return. We proceed to devise a volatility timing strategy based on statistical tests on the slope of the volatility decile portfolio's return profile. Volatility timing is achieved by being aggressive during strong growth periods, while being conservative during market downturns. Superior performance is obtained, with an additional return of 4.1% observed in the volatility timing strategy, resulting in a five-fold improvement on accumulated wealth, along with statistically significant improvement in the Sortini ratio and the Information ratio. The authors also demonstrate that stocks in the high-volatility portfolio are more strongly correlated compared to stocks in the low-volatility portfolio. Hence the profitability of the volatility timing strategy can be attributed to successfully holding a diversified portfolio during bear markets, while holding a concentrated growth portfolio during bull markets.

Keywords: portfolio management, asset allocation, low volatility strategies

JEL Classification: G11