Strategic Risk Management

CHAPTER 3Risk Management via Volatility Targeting

INTRODUCTION

In the first two chapters, we explored the performance of various types of investments during equity market drawdown periods and recessions. Understanding the historical track record of these investments is an essential component of strategic risk management. However, there are other tools in the investor’s arsenal that positively contribute to risk management, including rebalancing strategies (Chapter 4), drawdown strategies (Chapter 5), as well as the subject of this chapter, volatility targeting.¹

A portfolio strategy that targets certain levels of volatility may act similarly to the positive convexity strategies that we discussed in the first chapter. For example, research has documented two features of volatility. First, volatility is persistent (sometimes described as clustering). High volatility over the recent past tends to be followed by high volatility in the near future. This observation underpins Engle’s (1982) pioneering work on ARCH models.² Second, for equity markets there is a negative relation between volatility and return realizations. As a result, a portfolio strategy that targets a certain level of volatility will be reducing weights in assets where volatility is spiking, which naturally reduces the severity of drawdown.

In this chapter, we focus on a portfolio strategy that is designed to counter the fluctuations in volatility. We achieve this by leveraging the portfolio at times of low volatility, ...