Volatility Targeting — What Is That?

If you read news and articles regularly on the markets, you must have come across the term: Volatility Targeting. But how much do you know about it? During the first quarter of 2020, at the height of the COVID-19 pandemic, you heard of volatility targeting hedge funds deleveraging. What happens is that these funds usually took up debts to increase and finance their positions. And when a volatile market hits, they reduce their debts and size down the positions to lower the risk. In a severe market crisis, it can trigger a chain process where these funds start to deleverage one after another. This will further aggravate an already serious selloff.

Why Do These Funds Need Volatility Targeting?

Volatility targeting is about managing risk. The underlying concept is simple. When it looks risky, size down and play safe. And when it looks safe, size up and get the most out of the market. Of course, you might argue how we even know if markets will stay the way it is. And you are right. We don’t. Because markets can always just change course all of a sudden.

Now, if all that matters is your personal money, you can carry on even if you lose 50% or more. After all, you are only accountable to yourself. But if you are running a fund, then you have a lot more at stake. OTHER PEOPLE’S MONEY. Serious fund managers are well aware of the importance of risk management and the duty they have to their clients. They are not in the game of making bets and then just hoping it will turn out in their favor. Hope is the last thing you want to depend on. Because losing even 20% or 30% can mean the end of the business. Fund managers don’t have a crystal ball that can look into the future. Hence, from their perspective, it is prudent to decrease the risk during uncertain times to limit the damage should things turn out to be worse.

How Does Volatility Targeting Works?

Let’s say you want to run your portfolio at a target volatility of 15%. You can build a portfolio using any technique. Equal weight, minimum variance, risk parity, maximum Sharpe, or whatever. It also does not matter how many securities you have. These are entirely up to you. For illustration purposes, I will go with an equal-weighted portfolio with 3 securities A, B and C. To know how to size up your positions, you need to calculate the volatility of this portfolio as follows

To make things less complicated, I am also going to assume the correlations between the securities is 1.

Scenario 1: Calm Markets

We start with a “peaceful” scenario. Markets look stable and are moving up steadily. The volatility of the underlying securities in your portfolio is low. Based on the formula shown earlier, the annualized volatility of this portfolio works out to be around 6.3%. Let’s take it that the volatility of each security is computed from its daily returns over the past 3 months and then scaled to an annual figure. Alright, it doesn’t have to be 3 months, I am just citing an arbitrary length of time here.

But what is of relevance is that you are operating below your volatility target. So there is room for you to size up and take on more risk. If you want to hit your target of 15%, then you have to increase each of your position by a factor of 15% / 6.327% = 2.37. What this means is you need to leverage your portfolio by 2.37x. So instead of 33.3% to each position, it will be 78.9%. It is the same if you translate the weights to dollars and cents. If your position size is $100, you need to up it to $237.

Scenario 2: Crisis Mode

A crisis hits subsequently and markets turned violent. Your securities volatility spiked and your portfolio volatility more than doubled to 13.653%. What this translates to is a lower scope for leverage. To meet your portfolio target of 15%, you only need to increase the size of your positions by a factor of 15% / 13.653% = 1.1. Let’s assume you also rebalance the securities back to equal weights. So each position should be size to 36.3% now. And since you are operating at higher leverage before this, you need to deleverage to bring your portfolio back to your target risk level.

Scenario 3: Catastrophic Market Meltdown

Every once in a while, markets will be sent to ICU. That happened during 2008 after Lehman Brother collapsed. And more recently, during the chaos sparked off by the COVID-19 pandemic. Your portfolio volatility shoots off the roof and exceeds your 15% target. In this instance, you will adjust your position down by a factor of 15%/34.632% = 0.43. So instead of holding 33.33%, you will sell your position down to 14.33%. And part of your portfolio will be in cash.

How Often Should We Adjust The Portfolio?

There is no fixed science to this. Some do it on a periodic basis — daily, weekly, monthly, etc. The frequency usually entails tradeoffs pretty much like everything else. If you do it frequently, you adjust faster. But in return, you incur higher costs and run the chance of getting whipsawed by short term market movements. On the other hand, if you do it infrequently, the battle may be over when you adjust.

Thus, some practitioners prefer to adjust their portfolio when a threshold level is triggered. For example, you may want to adjust only when the portfolio volatility crosses below or above a 3% threshold from the target. So if 15% is the target, you will adjust when your portfolio volatility goes below 12% or above 18%.

You will also find others using a combination of both or some other rules.

Conclusion

What I have shown you is a simple way to implement Volatility Targeting. Different funds may do it differently. But the gist of it is similar.

Originally published at https://investmentcache.com on July 6, 2020.