Understanding Volatility-Managed Portfolios

Abstract

Contrary to the intuition that the standard risk-return tradeoff should lead to underperformance of a portfolio that scales down exposure during volatile periods a recent paper by Moreira and Muir (2017) actually shows that volatility-managed portfolios produce robust and significant alphas. The present paper investigates the mechanisms that lead to the outperformance of volatility management. By implementing timing regressions and relating returns of a volatility-managed portfolio to discount-rate, cash-flow and expected volatility news we provide evidence that volatility management outperforms by levering up good times without increasing downside exposure to fundamental risk drivers. On the contrary, during the most severe cumulative news shocks (either to cash flows, discount rates or expected volatility) the scaling strategy suffers less than the buy-and-hold portfolio and, thus, increases investor utility. Furthermore, we relate volatility-managed strategies to popular timing strategies based on a measure of risk-neutral variance as a lower bound for the expected equity risk premium. We find that strategies that combine elements from both, volatility management and timing based on risk-neutral variance, outperform over a recent sample period and produce significant alphas in spanning regressions, posing further puzzles for the asset pricing literature.

Keywords: volatility management, cash-flow news, discount rate news, market timing, portfolio management, investment strategies, risk-neutral variance, SVIX

JEL Classification: G11, G12, G14