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Benefits of Volatility Targeting Across Asset Classes

Posted in Bonds, Commodity Futures, Currency Trading, Equity Premium, Volatility Effects

Does volatility targeting improve Sharpe ratios and provide crash protection across asset classes? In their May 2018 paper entitled "Working Your Tail Off: The Impact of Volatility Targeting", Campbell Harvey, Edward Hoyle, Russell Korgaonkar, Sandy Rattray, Matthew Sargaison, and Otto Van Hemert examine return and risk effects of long-only volatility targeting, which scales asset and/or portfolio exposure higher (lower) when its recent volatility is low (high). They consider over 60 assets spanning stocks, bonds, credit, commodities and currencies and two multi-asset portfolios (60-40 stocks-bonds and 25-25-25-25 stocks-bonds-credit-commodities). They focus on excess returns (relative to U.S. Treasury bill yield). They forecast volatility using realized daily volatility with exponentially decaying weights of varying half-lives to assess sensitivity to the recency of inputs. For most analyses, they employ daily return data to forecast volatility. For S&P 500 Index and 10-year U.S. Treasury note (T-note) futures, they also test high-frequency (5-minute) returns transformed to daily returns. They scale asset exposure inversely to forecasted volatility known 24 hours in advance, applying a retroactively determined constant that generates 10% annualized actual volatility to facilitate comparison across assets and sample periods. Using daily returns for U.S. stocks and industries since 1927, for U.S. bonds (estimated from yields) since 1962, for a credit index and an array of futures/forwards since 1988, and high-frequency returns for S&P 500 Index and 10-year U.S. Treasury note futures since 1988, all through 2017, they find that:

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