Volatility Managed Portfolios

Abstract

Managed portfolios that take less risk when volatility is high produce large alphas, substantially increase factor Sharpe ratios, and produce large utility gains for mean-variance investors. We document this for the market, value, momentum, profitability, return on equity, and investment factors in equities, as well as the currency carry trade. Volatility timing increases Sharpe ratios because changes in factor volatilities are not offset by proportional changes in expected returns. Our strategy is contrary to conventional wisdom because it takes relatively less risk in recessions and crises yet still earns high average returns. This rules out typical risk-based explanations and is a challenge to structural models of time-varying expected returns.

Investor Myopia and the Momentum Premium across International Equity Markets

“…If investors can reasonably predict periods in which the probability of negative momentum returns are high, then rational investors are likely to reduce the impact of the drawdowns on the momentum strategy by dynamically adjusting their momentum exposure. Dynamic volatilitymanaged portfolios have been shown to increase risk-adjusted returns across a range of equity market factors (Moreira and Muir (2017)), with the benefits from volatility management being most substantial for the momentum and bettingagainst-beta factors (Barroso and Maio (2016)). In this section, we test the robustness of the relationship between momentum returns and myopia by using a risk-adjusted momentum strategy recently established in the literature (Barroso and Santa-Clara (2015)).…”

“…We rule out both risk and investor overreaction as potential alternative explanations for our results. Given that recent evidence has demonstrated the efficacy of a volatility-managed momentum strategy (Moreira and Muir (2017), Barroso and Santa-Clara (2015)), we also examine a risk-managed momentum strategy; the resultant returns are also related to country-level myopia.…”

Deleveraging Risk

“…There are at least three nonmutually exclusive explanations for why levered investors may be unable to maintain levered positions during periods of capital scarcity. First, portfolio managers may voluntarily reduce the leverage of their portfolios to maintain a desired ex ante risk level in response to economy-wide liquidity shocks (Kyle and Xiong (2001), Xiong (2001), Bollerslev, Hood, Huss, and Pedersen (2016), and Moreira and Muir (2017)). If market volatility increases, investors might choose to employ less leverage in their portfolio.…”

Volatility‐managed commodity futures portfolios

“…Moreira and Muir (2017; MM) suggest a simple volatility‐managed portfolio can improve profitability in the equity market. The volatility‐managed portfolio is a portfolio whose monthly return is scaled by the inverse of its previous month's realized variance.…”