For “superior” risk-adjusted returns, investors should take less risk when markets are volatile, Yale academics have argued.
Volatility-managed portfolios—those that decrease risk exposure when returns are expected to be volatile, and vice versa—produce large, positive alphas and increase Sharpe ratios by “substantial” amounts, according to a study by Assistant Professors of Finance Alan Moreira and Tyler Muir.
“We find that short- and long-term investors alike can benefit from volatility timing, and that utility gains are substantial,” they wrote.
While the “common advice” is to increase or maintain risk levels following a downturn, a volatility-managed portfolio reduces risk during these volatile periods. For example, rather than buy equities following the 2008 market crash, the volatility-managed portfolio “cashed out almost completely and returned to the market only as the spike in volatility receded.”
“An investor is better off paying attention to conditional volatility… suggesting that volatility is a key element of market timing.”“Since volatility movements are less persistent than movements in expected returns, our optimal portfolio strategy prescribes a gradual increase in the exposure as the initial volatility shock fades,” Moreira and Muir continued.
The pair concluded that it takes an average of 18 months for risk exposure to return to normal, beyond which they advised even further exposure to capture the persistent increase in expected returns.
“The difference in persistence allows investors to keep much of the expected return benefit, while at the same time reducing their overall risk exposure,” they argued.
For the study, Moreira and Muir constructed volatility-managed portfolios across market, value, momentum, profitability, return on equity, equity investment factor, and currency carry trade strategies, and plotted their returns from 1926 to 2015. They found that annualized alphas were “substantial,” with Sharpe ratios increasing by 50% to 100%.
The results were positive for both short-term investors, who are affected by all types of volatility, and long-term investors, who typically disregard more transient price movements, as they can afford to wait until the price recovers.
For both short- and long-term investors, the Yale professors recommended a combination of a buy-and-hold portfolio and a volatility-managed portfolio as the best method of achieving high risk-adjusted returns.
“Volatility-managed portfolios offer superior risk-adjusted returns and are easy to implement in real time,” Moreira and Muir concluded. “An investor is better off paying attention to conditional volatility… suggesting that volatility is a key element of market timing.”