Volatility targeting systematically keeps risk in the portfolio on track. But the same mechanics can become a stress test in times of crisis.
• Dynamic risk
• Volatility targeting: leverage and rebalancing
• Case study: Corona
What is volatility and why does it matter?
Before volatility targeting can be understood, there needs to be a clear foundation: Volatility describes the price fluctuations of a security in the past. It is the annualized standard deviation of daily returns. To calculate volatility over a year, the fluctuation range of the last year’s daily performance is averaged and extrapolated to one year. The higher the annual volatility, the more the security fluctuates, although the level of volatility says nothing about the quality of a security.
By comparing the volatility of a security’s return, it is possible to measure exactly how much risk was taken for a particular return. This is exactly where volatility targeting comes in: the risk should not be left to chance in the market, but should be actively managed.
What is volatility targeting?
Volatility targeting means that a fund or ETF dynamically adjusts its risk to achieve a set target volatility: for example 10 percent per year. Instead of remaining rigid, the ETF changes its position size or leverage as the expected range increases or decreases. This means that more risk is taken in calm phases and reduced in turbulent times, as etf.capital describes.
A related strategy is risk parity funds: Here, each asset class also contributes the same proportion of risk to the overall portfolio, so that the risk is distributed evenly across all positions, as the ECB explains.
Market relevance and scale
In the years before the coronavirus outbreak, low market volatility strongly drove the popularity of these strategies. Low volatility across all major asset classes and regions has been a defining feature of global asset price developments up to this point, the ECB notes. Globally, it was estimated that up to $2 trillion was invested in various forms of volatility strategies, including around $300 billion in risk parity funds.
Mechanism: Leverage and Rebalancing
Funds or ETFs that pursue volatility targeting strategies invest in different asset classes with a specified portfolio volatility target and can use leverage when market volatility and correlations are low, as the ECB explains. Rebalancing usually takes place daily or weekly, based on a short-term volatility estimate such as the 30-day standard deviation. If the measured volatility is 12 percent above the target, the fund reduces the exposure by around 20 percent. If it falls to 8 percent, it will be increased again accordingly, according to etf.capital.
Procyclicality as a systemic risk
It is precisely this automatism that harbors a structural weakness. A central feature of these strategies is the procyclical connection between leverage and volatility: in phases of low market volatility, the volatility targets allow higher leverage and thus larger positions in financial assets. Conversely, fund managers need to exit leveraged positions when market volatility and cross-asset class correlations increase. In doing so, they increase the selling pressure on the markets, precisely when it is already high.
Case study: March 2020 market collapse
The market collapse in spring 2020 clearly demonstrated how consequential this mechanism can be in practice. As of mid-March 2020, backward-looking volatility measurements were still below target in all asset classes except equities. This environment allowed risk parity investors to leverage their positions in bonds and stocks up to twice the assets under management, as the ECB writes.
In March, volatility suddenly increased across all asset classes. The consequence particularly affected professionally managed portfolios: asset managers with regulatory volatility limits had to sell some of the securities because the measured volatility was suddenly too high for the specified limits and thus missed the rapid upswing that followed. However, those who invested independently or without fixed volatility targets were able to benefit massively from the V-shaped correction.
Markus Maier, editorial team at finanzen.net