A complicated way to do something very simple

The financial industry has a knack for reinventing the wheel in a slightly more complicated fashion than before. So many financial products can be replicated with a combination of standard products like an equity fund, a savings account, and a couple of bonds. Case in point? Benjamin Hood and Cameron Raughtigan from Morgan Stanley examined volatility targeting funds.

Volatility targeting funds has become somewhat of a fashion over the last decade. They promise returns that are more stable than a classic fixed allocation portfolio that invests in stocks and bonds in constant ratios. Historically, these volatility-targeting funds have managed to create alpha vs. a simple buy-and-hold strategy.

That’s great, but where does that alpha come from?

If we look at the average of past 1-, 3-, and 12-month returns for the positions held in volatility-targeting portfolios we can get an idea of where to look. Assets with higher past returns tend to get larger allocations in volatility-targeting portfolios than assets with poor past returns.

Average past returns by volatility targeting position

Source: Hood and Raughtigan (2024)

Looks very much like a simple momentum strategy or a trend-following strategy if you ask me.

This is also what the research shows. If stock markets rally, their volatility tends to decline. Volatility targeting funds then load up more on stocks because of this lower volatility. This feedback loop continues until the trend breaks and shares start to drop. If the drop is gradual and looks like a rounded top, volatility-targeting funds register a gradual increase in volatility and have enough time to unload stocks before things get ugly.

But if the trend reversal is sudden like in the pandemic panic of March 2020 or more recently, but to a much smaller degree, during the August carry trade unwind in the US, then volatility targeting funds are in trouble. Because of their trend-following nature, they are heading into the sell-off with maximum equity exposure and then reducing their exposure just when markets are about to recover.

The result is that volatility-targeting funds have the same return signature as a simple trend-following strategy in equities. They work most of the time but are vulnerable to momentum crashes. Interestingly, though, this relationship between higher returns and lower volatility exists mostly in equity markets. For bonds and commodities, the study authors found much less negative correlation indicating that volatility targeting funds in fixed income and commodities face fewer crash risks but also are less likely to outperform a simple buy and hold strategy simply because they tend to exploit trending markets to a lesser degree.

Correlation between asset returns and market beta

Source: Hood and Raughtigan (2024)

But if volatility targeting funds in the equity space is simply a complex way to exploit trend following, why bother with the higher fees charged by these products? You could simply buy a traditional equity fund of your choosing (active or passive, both will work) and follow the simple 200-day moving average rule. Meb Faber has shown convincingly that this simple strategy works much better than buy and hold and reduces downside risks significantly, not just for equities but a host of other asset classes as well. But of course, the fees generated by such a simple strategy are much lower than the fees generated by a volatility targeting fund…