Volatility Targeting — What Is That?

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.

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

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.


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.



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