Forecasting and Managing Volatility: An S&P 500 Case Study

Working paper, forthcoming in the Journal of Investment Management.

27 Pages Posted: 26 Nov 2024 Last revised: 4 Dec 2024

See all articles by Wei Dai

Wei Dai

Dimensional Fund Advisors

Xing Hong

Dimensional Fund Advisors

Robert C. Merton

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Harvard Business School - Finance Unit

Mathieu Pellerin

Dimensional Fund Advisors

Date Written: November 06, 2024

Abstract

Using daily and intraday data from 1997 to 2023, we study strategies that stabilize volatility around a target by rebalancing between the S&P 500 and Treasury bills based on a broad set of volatility forecasts. Somewhat counterintuitively, lower forecasting errors do not necessarily result in more stable strategy volatility. Simple forecasts with fewer parameters can stabilize volatility as well as more complex models. In particular, combinations of implied volatility and simple estimators based on past returns exhibit good volatility control and lower turnover. On the implementation front, we show that the target volatility strategies we study are viable in the presence of realistic trading costs, delays between forecasting and rebalancing, or constraints on rebalancing frequency. Collectively, our findings can help design target volatility strategies that improve upon portfolios with constant target weights (e.g., a 60/40 portfolio) in achieving and maintaining investors' desired volatility exposures over time.

Keywords: Volatility-managed portfolios, volatility forecasting, realized volatility, asset allocation

Suggested Citation

Dai, Wei and Hong, Xing and Merton, Robert C. and Pellerin, Mathieu, Forecasting and Managing Volatility: An S&P 500 Case Study (November 06, 2024). Working paper, forthcoming in the Journal of Investment Management., Available at SSRN: https://ssrn.com/abstract=5013407 or http://dx.doi.org/10.2139/ssrn.5013407

Wei Dai

Dimensional Fund Advisors ( email )

6300 Bee Cave Road, Building One
Austin, TX 78746
United States

Xing Hong

Dimensional Fund Advisors ( email )

6300 Bee Cave Road, Building One
Austin, TX 78746
United States

Robert C. Merton

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

77 Massachusetts Avenue
E62-634
Cambridge, MA 02139-4307
United States
617 715 4866 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6678 (Phone)

Mathieu Pellerin (Contact Author)

Dimensional Fund Advisors ( email )

6300 Bee Cave Road, Building One
Austin, TX 78746
United States

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