Tail-Risk Mitigation With Managed Volatility Strategies: Research Paper

Journal of Investment Strategies 8(1), 29–56
DOI: 10.21314/JOIS.2019.107
Research Paper
Tail-risk mitigation with managed volatility

strategies
Anna A. Dreyer and Stefan Hubrich
T. Rowe Price, 100 E. Pratt Street, Baltimore, MD 21202, USA;

emails: Anna dreyer@troweprice.com, Stefan hubrich@troweprice.com
(Received November 7, 2018; accepted February 21, 2019)
ABSTRACT
Managed volatility strategies adjust market exposure in inverse relation to a risk
estimate, to stabilize realized portfolio volatility through time. Our paper examines
strategy performance from an investment practitioner perspective. Using long-term
data from the Standard & Poor’s 500, we show that these strategies offer an improve-
ment in risk-adjusted return compared with a buy-and-hold benchmark, on average,
but with some variation. Managed volatility strategies achieve robust tail-risk reduc-
tion while also enhancing skewness. These return normalization features are inher-
ently linked to the nature of the volatility stabilization mechanism. We illustrate them
via utility-based metrics that reward the tail-risk reduction emanating from volatility
stabilization. These enhancements are economically meaningful for many time hori-
zons and holding period combinations, and they remain once transaction costs have
been included, suggesting a durable and tangible value-add from managed volatility
strategies. They also suggest a more appropriate way to measure the performance
improvements of tail-risk-mitigating strategies.
Keywords: managed volatility (MV); tail-risk mitigation; return distribution normalization;

utility-based performance metrics.
Corresponding author: A. A. Dreyer Print ISSN 2047-1238 j Online ISSN 2047-1246

c 2019 T. Rowe Price Associates, Inc.
29
Electronic copy available at: https://ssrn.com/abstract=3074529

30 A. A. Dreyer and S. Hubrich
1 INTRODUCTION
Managed volatility strategies adjust market exposure in inverse relation to a risk esti-
mate, with the aim of stabilizing realized portfolio volatility through time. While
volatility stabilization is achievable with relative ease, owing to the general pre-
dictability of volatility, or volatility clustering, it is not by itself of obvious bene-
fit to investors. Advocates for these strategies typically argue that they also provide
higher risk-adjusted returns, most likely due to countercyclicality in the risk/return
relationship of the underlying equity market itself. A robust and broadly constructive
empirical body of literature has developed on this topic over the last decade, but the
time periods and success metrics used vary greatly, leaving investors wanting for a
robust set of stylized facts as their guide. Our paper examines managed volatility
performance under a range of success metrics that align with how investment prac-
titioners often evaluate investment strategies, including explicit consideration of a
time horizon (holding period). We rely on a much longer data set than is typically
seen in the volatility management literature. We employ a utility-based approach as
a way of capturing the effect of the strategy on higher moments. Our key finding
is that, while managed volatility is associated with varying improvements in risk-
adjusted return, it produces robust enhancements in tail-risk reduction. We believe
this perspective is both novel and important because it refocuses the case for the
strategy on its inherent risk management characteristics, rather than being a targeted
focus on its risk-adjusted performance enhancement, as tail-risk reduction is a direct
consequence of the volatility stabilization mechanism.
Perchet et al (2014a) provide a useful conceptual framework by examining, both
theoretically and through simulation, a wide range of conditions under which Sharpe
ratio enhancement from managed volatility can arise. When applying their approach
to Standard & Poor’s 500 (S&P 500) data (1990–2012), they find a meaningful
Sharpe ratio improvement. Perchet et al (2014b) apply the same approach to factor
returns. Hallerbach (2012) focuses more on the theoretical argument for the superior-
ity of managed volatility portfolios, but he also demonstrates a Sharpe ratio improve-
ment for European equity markets over the 2003–11 period. Moreira and Muir (2017)
put their emphasis on the conditional Sharpe ratio of the underlying asset as the main
channel for Sharpe ratio improvements in managed volatility portfolios.1 Using a
1 If forward volatility is predictable but the forward return is not related to the volatility forecast,
then volatility forecasts also predict time-varying Sharpe ratios that are higher when volatility
is predicted to be low. The assumption that forward returns are entirely unrelated to predicted
volatility also leads Moreira and Muir (2017) to focus on “variance-managed” portfolios, which
allocate to equities in inverse relation to expected variance rather than expected standard deviation.
Our paper makes the baseline assumption that Sharpe ratios are invariant to predicted risk, which
implies allocating inversely to standard deviation rather than variance.
Journal of Investment Strategies www.risk.net/journals

Tail-risk mitigation with volatility management 31
wide range of underlying assets and assuming a Sharpe ratio maximizing mean–
variance investor, they find Sharpe ratio improvements from managed volatility in a
wide range of cases.
Fleming et al (2001) use a quadratic utility approach and find meaningful improve-
ments from managed volatility portfolios, albeit over a somewhat narrow time period
(1983–97). In Fleming et al (2003), the same group of authors demonstrates the
benefit of using intraday “realized” volatility for the volatility forecast. Another
highly relevant paper is Hocquard et al (2013), which focuses on tail-risk mitiga-
tion from managed volatility strategies, employing a sophisticated payoff transfor-
mation procedure to explicitly target a certain realized return distribution. Looking
at a global equity portfolio for the 1990–2011 period, the authors find meaningful
tail-risk reduction in addition to a substantial Sharpe ratio improvement. Using a
utility-based approach, they are able to holistically score all aspects of the return.
Similarly, Moreira and Muir (2016) calibrate outright structural models to empir-
ical data in order to include a wider range of utility preferences. They find large
utility improvements from managed volatility portfolios.2 In the existing literature,
the paper by Dopfel and Ramkumar (2013) is most similar to ours. Like this paper,
they use a relatively long historical sample (starting in 1950) and employ utility-
based analysis. Focusing on quarterly holding periods, they find a small Sharpe ratio
improvement and a more meaningful utility improvement from managed volatility
strategies. However, they do not explicitly recognize the link between the greater
utility improvement and the impact of the strategy on the higher moments of return
(tail-risk hedging). To draw out that link is the main point of our paper. We also
expand on their work by considering results across a range of possible investor hold-
ing periods, and by using higher-frequency data (daily rather than quarterly), which
helps our findings to align better with how investors likely employ the strategy in
practice. Finally, Dreyer et al (2016) make a relevant contribution to the literature by
illustrating how managed volatility strategies can be combined with other strategies
for portfolio enhancement.
2 WHY MIGHT MANAGED VOLATILITY BE WORTH HAVING?

Managed volatility (MV) strategies rely on the ability to forecast near-term risk.
As a simple illustration, consider that across our sample covering US equity mar-
ket data since 1926 (see our first appendix (available online) for data sources and
2 We also note that there is a related and older literature dealing with the conditional Sharpe ratio
of the underlying equity markets. We do not review this literature in detail, referring the reader
instead to some of the more recent papers: Lettau and Ludvigson (2010), Brandt and Kang (2004),
Lundblad (2007) and Tang and Whitelaw (2011), and the references therein.
www.risk.net/journals Journal of Investment Strategies

calculation details), the return correlation between adjacent sixty-trading-day peri-

ods is essentially zero. In contrast, the correlation rises to 0.55 for risk as measured
by standard deviation. Past returns do not predict future returns, but past volatility
certainly predicts future volatility.
The immediate use case for this ability to forecast risk is to stabilize realized port-
folio volatility. This can be accomplished by frequently recalibrating equity market
exposure such that the expected portfolio volatility under the forecast aims at a con-
stant target. Figure 1 illustrates this concept. We show the rolling realized sixty-day
volatility for two portfolios: the raw equity market (the static benchmark) and a styl-
ized MV strategy.3 Figure 1 clearly shows the volatility stabilization attribute of the
MV strategy, as its realized volatility consistently hugs the target volatility within a
much tighter range than the benchmark. This observation holds even during turbulent
market episodes such as the mid-1970s, the 1987 crash, the tech bubble/crash of the
early 2000s and the global financial crisis (GFC) of 2008–9.
There are several investment applications where this volatility stabilizing feature is
valuable. The primary example is the variable annuity industry, where many policies
are sold with guarantees pertaining to a certain withdrawal stream from the under-
lying assets. That liability resembles a complex equity index option portfolio, and,
by applying MV strategies to the underlying assets, insurers can stabilize and even
reduce the hedging costs associated with their variable annuity book.
Second, stabilizing volatility can also enhance the suitability of portfolios that
advisors manage for their clients. Client portfolios are often picked from a range
of models with different long-term risk characteristics, based on questionnaires and
client preferences expressed elsewhere. A traditional model, like the line labeled
“BM” in Figure 1, likely exhibits a fluctuating volatility profile that often differs from
the long-term “bucket” in which the client has been placed. MV strategies could be
deemed more suitable, as their risk characteristics are more stable through time.
Third, individual investors often overreact to fluctuations in volatility by selling
out of risky strategies at inopportune times. See Kinnel (2015) for a study along
those lines, which compares investment returns to investor returns, with the latter
also capturing the timing of buy and sell decisions. The author demonstrates that this
gap widens with the volatility of the underlying investment. Hence, an MV strategy
that attenuates the benchmark fluctuations shown in Figure 1 may reduce adverse
trading behavior and close this gap.
3The MV strategy dynamically alters the daily equity market exposure according to the ratio of
realized past long-term equity volatility and the trailing twenty-day realized volatility. The former
represents the volatility target and the latter, the forecast.

FIGURE 1 Comparison of the realized trailing sixty-day volatility of the benchmark (BM)
and MV strategies for the data sample starting in 1929.
BM MV Target
0
1940 1950 1960 1970 1980 1990 2000 2010
The dynamic allocation process inherent in MV can seem antithetical to the value-
conscious, somewhat contrarian nature of many professional investors. Equities tend
to be cheap when volatility is high. Interestingly, Moreira and Muir (2017) illus-
trate that market valuation signals and MV strategies are complementary. Their key
insight is that valuation is best at forecasting returns for very long time horizons,
while MV strategies tend to react dynamically to shorter-term trends in volatility. As
long as the gains from attractive valuations are harvested in the long term rather than
immediately following an attractive valuation observation, MV does not lose much
expected return by lowering exposure immediately after a sell-off. It is entirely pos-
sible that most of the long-term future gains from a low valuation starting point are
harvested during normal or even low-volatility periods, when MV features healthy
equity exposure.
We also need to recognize that MV strategies can and will routinely employ
leverage, here defined as equity exposure in excess of 100% during low-volatility

episodes. The strategy depicted in Figure 1 employs leverage on 64% of days.4 The
mean and median daily equity exposures are 134% and 122%, respectively.5
The use of leverage during low-volatility periods allows MV to garner excess
returns over the benchmark during these periods if the underlying market returns are
positive. As such, outperformance of MV strategies in calm periods, such as 2017,
is often overlooked. It is the main feature that can compensate for opportunities lost
by de-risking in crisis periods. MV would employ leverage whenever the short-term
volatility forecast for the underlying market falls below the long-term target. In Fig-
ure 1, these periods are largely consistent with the benchmark short-term volatility
falling below the target. The larger the deviation, the larger the degree of lever-
age. However, in high-volatility periods, MV also significantly reduces exposure
below 100%.
Further, return as the key measure of success becomes meaningless for strate-
gies that can employ leverage. As long as the underlying market returns are pos-
itive on average, additional leverage can be applied to achieve the desired return
target. Therefore, what matters is risk-adjusted return: how much return does the
portfolio garner per unit of risk? We will focus on the Sharpe ratio (SR), defined
as the average excess return divided by standard deviation, as the most commonly
used metric for risk-adjusted return. Our question then becomes the following: why/
when would we expect MV to have a higher SR than the benchmark? The litera-
ture provides us with several relevant considerations here (see Perchet et al (2014a)
for a detailed study on this topic). The primary driver is the conditional SR of the
underlying equity market itself. There is a large body of existing literature suggest-
ing that, broadly speaking, realized equity market SR is lower when risk is high.
This is referred to as market level SRs being countercyclical. It would make MV
an excellent market timing device, featuring more exposure when market level risk/
reward is attractive (volatility is low), and vice versa. In fact, the MV strategy con-
templated here, which scales exposure inversely to volatility rather than variance,
would be suboptimal. As shown in Moreira and Muir (2016), the optimal strategy in
the extreme case of expected returns that are invariant to predicted volatility would
be a “variance-managed” portfolio that allocates to the equity market inversely to
predicted variance.
We focus our study on MV relative to standard deviation because it is defensi-
ble under much weaker conditions: if the equity market SR is at least constant, MV
should not fall below the benchmark with regard to the long-term SR (Kolanovic
and Wei 2013). Outright countercyclicality is unnecessary. As practitioners, we also
4The illustrated strategy is unconstrained and rebalanced daily.

5Daily equity exposure at the 10th, 25th, 75th and 90th percentiles is 57%, 83%, 171% and 224%,
respectively.

note that MV strategies – as we define them – constitute an actual investment cat-

egory in the market place. Further, the results of our paper themselves support our
approach. While we generally find improvements in the SR historically, the degree of
this improvement is period dependent. We also demonstrate that volatility-stabilized
strategies have distinct tail-risk hedging benefits that can and do accrue in the absence
of time-varying market level SRs.6
Last, if an MV long-term SR does not fall below that of the underlying equity mar-
ket, as Kolanovic and Wei (2013) suggest, and leverage can be applied, the compound
returns of MV should approximately scale with the target volatility.7 In this paper,
we have selected a target level of volatility consistent with the underlying equity
market. However, other levels of fixed or varying target volatility could have been
selected. This is commonly done in practitioner portfolios. In these cases, different
degrees of leverage could be applied by reducing the allocation to the underlying
equity market, thus reducing the compound return and volatility while retaining the
risk-adjusted return. This paper does not use fixed target volatility to avoid lookahead
bias in selecting the fixed target.
3 TRADITIONAL RISK-ADJUSTED PERFORMANCE EVALUATION

We focus our analysis on US data, which provides us with a very long-term sample
of daily returns, starting in 1926. One of our key concerns is stability of findings
through time. Several studies have established MV attributes for a wide range of
assets, but our concern is that the emphasis on breadth restricts them to a sample
length of no more than two to three decades, a sample heavily influenced by the
GFC. We believe that our US-only, but very long-term, study provides an important
cross-check to those findings.8
We focus on two forms of robustness in the time dimension: across sample peri-
ods, and across holding periods within each sample period. The holding period is
6 A second reason to expect a higher SR from MV lies in its longitudinal diversification benefits.
By targeting constant risk through time, each period allocates equally to the time series risk of the
MV return stream. In theory, this should provide better risk-adjusted returns, much like the effect
of cross-sectional diversification. In the extreme case of uncorrelated assets, the SR maximizing
point-in-time portfolio will allocate equal risk to each asset. Perchet et al (2014a) investigate this
angle but conclude that, in practice, this benefit is not economically meaningful.
7 The impact of MV on risk-adjusted returns should be relatively independent of the volatility target
if cash is used as the de-risking asset to avoid asset allocation effects.

8 In addition, global equity markets are strongly correlated, especially during periods of turbu-
lence. This correlation has increased as global markets have become increasingly interconnected.
We believe that looking at a longer longitudinal sample, as opposed to one with broader regional
representation, offers a more powerful robustness test.

the frequency at which the investor evaluates performance. In other words, it is the
time window over which individual return observations are cumulated. Here, hold-
ing period refers only to the window length over which daily returns are aggregated,
not the rebalancing frequency.9 Our data is daily, and we permit daily trading. We
view the problem through the lens of an investment manager offering an MV prod-
uct. That product may have a diverse investor base with a variety of holding periods
of interest. Thus, our focus is on an unconstrained, daily traded MV strategy that has
the potential to maximize benefits from volatility management. In our experience
as practitioners, these strategies are actually managed in this manner. They can be
rebalanced daily, as warranted by changes in the volatility signal used, and they can
include large daily trades in liquid futures to adjust the risk profile.10
Table 1 presents our findings concerning traditional and risk-adjusted perfor-
mance.11 For a baseline MV strategy relying on trailing twenty-day realized volatility
as its forecast, the longest sample (starting in 1929) features meaningful SR improve-
ments to the order of 20–30% for holding periods up to a quarter. The deterioration of
the improvement as the holding period lengthens is noteworthy, however. Our analy-
sis confirms the notion that truly long-term investors, with holding periods beyond
one year, should not expect much of an enhancement from MV strategies. In fact, we
see a degree of SR underperformance from MV strategies at these horizons. It seems
that for a long enough horizon, the long-term growth potential and mean-reversion
tendencies of equity markets are the more important principle.12 We also compute the
(nonannualized) alpha for each holding period.13 While the alpha is positive up to a
three-year holding period, the marginal improvement in the alpha begins to degrade
for holding periods beyond three months. Alphas are significant for up to one year
when using data starting in 1926, but they are only significant for holding periods up
to one day and one month, respectively, when using data starting in 1960 and 1990.
The degree of the SR enhancement from MV varies based on the time period of
interest. We first show this in Table 1 by also providing results for subperiods starting
9 See, for example, Perchet et al (2014a) for an MV study employing lower-frequency rebalancing
periods.
10 We do acknowledge that investment practitioners will likely put some guardrails around daily
trading behavior, however, and our second appendix (available online) re-evaluates key results
under such constraints; they are unaffected by these considerations.
11 The MV series shown in Table 1 are constructed using a twenty-day trailing realized volatil-
ity estimate as the forecast. Metrics are shown based on returns in excess of cash and are not
annualized. See the online appendix for further information.
12 See Moreira and Muir et al (2017) for a confirmatory and quite nuanced discussion of the role
time horizons play in the comparison between MV strategies and valuation centric strategies.
13 Alpha regression allows for variable beta to the benchmark.

in 1960 and 1990.14 The smallest improvement is seen for the period starting in 1960.
For the period starting in 1990, we again see improvements, but these are not quite as
material as when we start in 1929. Confidence intervals contain positive differences
only for the 1929 period for horizons up to sixty days. It is worth emphasizing that
this last sample period, and the various subperiods therein, is the most frequently
used in the existing literature.
Another way to evaluate robustness is shown in Figure 2. This displays the bench-
mark and MV SR that arises in the sample, beginning with the time indicated on
the horizontal axis and ending in June 2018 (the end of our sample). This visual aid
illustrates the impact of the starting period on the risk-adjusted performance of MV
compared with the benchmark. We start the chart on the right in June 2013, assum-
ing that any backtest would show at least five years of data. Starting the backtest in
2013, the benchmark outperforms MV with a higher SR. MV only begins to have a
better SR when the GFC is included, starting in 2007. From then on, the two remain
close until the Great Depression, which finally gives MV its edge for the full sample.
It is fair to say that this is not a robust picture for those looking for a reliable SR
improvement from MV. Investors pursuing pure MV strategies for SR enhancement
should consider the potential for regret risk, even with a long-term commitment to
the strategy.
Pure MV strategies are characterized by material turnover and trading activity due
to their dynamic adjustment of exposures, permitting equity exposure that can be
dramatically different from the benchmark for periods of time. Not all investors have
an appetite for such high turnover or tracking error to the static benchmark. Varying
the forecast horizon via its trailing window length is one convenient way of sizing
the degree to which MV is added to the portfolio, as volatility forecasts based on
longer windows inherently lead to more stable exposures. Further, a naive notion
of symmetry might suggest using longer trailing windows, and thus slower moving
forecasts, if the MV strategy is evaluated over a longer holding period, and vice
versa. To investigate this further, Table 2 shows how the key results for the longer
sample period starting in 1929 are affected when using trailing windows longer or
shorter than the twenty days employed so far for forecasting volatility.
14For each holding period, we construct all nonoverlapping histories possible based on daily
returns, aggregate returns to the holding period, calculate the statistic within each history and then
average the statistics across histories. These statistics are not annualized. This approach is used for
the results shown in all tables. All returns are in excess of cash. MV is constructed using trailing
twenty-day realized volatility as the volatility forecast. Bootstrap 90% confidence intervals (5th
and 95th bootstrap percentiles) on differences in SRs shown between MV and the benchmark are
displayed. See the first appendix (available online) for details on data and analysis.

38
TABLE 1 Risk-adjusted performance comparison for the benchmark (BM) and MV strategies over discrete nonoverlapping windows with
varied holding periods. [Table continues on next two pages.]
20 days 60 days 240 days 720 days 2400 days

1 day (1 month) (3 months) (1 year) (3 years) (10 years)
A. A. Dreyer and S. Hubrich
Journal of Investment Strategies

‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ
BM MV BM MV BM MV BM MV BM MV BM MV
1929–2018
Annualized 5.99% 8.10%
geometric
return
Average 0.03% 0.04% 0.59% 0.78% 1.80% 2.39% 7.43% 10.32% 23.99% 35.15% 98.75% 171.83%
return
Risk (SD) 1.06% 1.06% 5.06% 5.56% 9.32% 10.27% 19.07% 25.49% 33.38% 55.58% 89.45% 189.68%
Sharpe ratio 2.71% 3.45% 11.65% 13.97% 19.36% 23.23% 39.00% 40.57% 72.49% 63.87% 111.76% 92.87%
Difference in 0.74% 2.32% 3.87% 1.57% 8.62% 18.89%
Sharpe ratio
90% CI of [0.1%, 1.4%] [0.3%, 4.4%] [0.4%, 7.1%] [ 5.0%, 7.0%] [ 21.1%, 2.2%] [ 75.7%, 2.7%]
Sharpe ratio
difference
Alpha (bps) 1.27 22.31 70.45 185.98 158.40 2023.67
90% CI of [0.6, 1.9] [11.1, 32.2] [32.8, 104.4] [41.7, 308.3] [ 329.6, 531.5] [ 5780.5, 634.9]
Alpha (bps)

www.risk.net/journals
TABLE 1 Continued.
‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ
1960–2018
geometric
return
Average 0.03% 0.03% 0.52% 0.63% 1.57% 1.92% 6.46% 7.95% 18.77% 22.88% 63.35% 79.83%
return
Risk (SD) 0.97% 0.97% 4.40% 5.04% 7.73% 9.00% 16.10% 19.21% 27.93% 34.93% 64.50% 89.06%
Sharpe ratio 2.60% 2.99% 11.71% 12.43% 20.31% 21.33% 40.24% 41.40% 67.42% 65.75% 106.21% 91.08%
Difference in 0.39% 0.72% 1.01% 1.16% 1.67% 15.13%
Sharpe ratio
90% CI of [ 0.3%, 1.1%] [ 1.7%, 3.2%] [ 3.8%, 5.3%] [ 8.2%, 9.1%] [ 17.4%, 12.0%] [ 231.8%, 14.7%]
Sharpe ratio
difference
Alpha (bps) 0.75 10.88 30.97 107.27 293.64 582.41
90% CI of [0.1, 1.4] [ 1.6, 22.5] [ 7.2, 67.1] [ 53.6, 252.1] [ 164.7, 771.4] [ 7254.6, 971.9]
Alpha (bps)

Tail-risk mitigation with volatility management
39
40
TABLE 1 Continued.

‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ

1990–2018
geometric
return
Average 0.03% 0.04% 0.65% 0.81% 1.97% 2.44% 8.37% 10.36% 26.09% 32.97% 74.32% 99.62%
return
Risk (SD) 1.10% 1.10% 4.39% 4.75% 7.48% 8.33% 16.03% 19.20% 33.43% 42.43%
Sharpe ratio 2.99% 3.61% 14.88% 17.03% 26.35% 29.39% 52.55% 54.20% 79.47% 78.90%
Difference in 0.61% 2.16% 3.04% 1.65% 0.57%
Sharpe ratio
90% CI of [ 0.4%, 1.7%] [ 1.6%, 5.8%] [ 4.4%, 9.9%] [ 16.7%, 10.6%] [ 21.4%, 32.2%]
Sharpe ratio
difference
Alpha (bps) 1.16 19.24 53.68 161.20 404.73
90% CI of [0.0, 2.2] [3.0, 36.4] [ 6.7, 107.9] [ 116.1, 311.7] [ 248.2, 1302.9]
Alpha (bps)

SD, standard deviation. CI, confidence interval.
FIGURE 2 Comparison of the benchmark (BM) and MV SRs calculated from a sample
beginning with the time indicated on the horizontal axis and ending in June 2018.
0.8
BM
MV
0.7
0.6
Sharpe ratio
0.5
0.4
0.3
0.2
1940 1950 1960 1970 1980 1990 2000 2010

Start of data sample
TABLE 2 SR results by trailing windows used for volatility forecasts for benchmark and
MV strategies evaluated over discrete windows with varied holding periods (1929–2018).

Benchmark 2.71 11.65 19.36 39.00 72.49 111.76

MV (10-day) 3.49 14.04 23.56 41.25 64.16 82.06
MV (20-day) 3.45 13.97 23.23 40.57 63.87 92.87
MV (30-day) 3.31 13.37 22.16 38.55 62.84 88.29
MV (60-day) 3.30 13.40 22.30 38.01 60.25 81.67
Perhaps surprisingly, short windows with more responsive forecasts are superior
even for longer holding periods. Of course, even though we may evaluate over a
longer holding period, the strategy will still adjust exposure daily. It thus makes sense
that the dynamics of the forecast should be governed by the trading frequency and not
by the evaluation period. One implication is that if turnover or tracking error present
a material concern, it may be more effective to manage them directly via explicit

constraints on portfolio construction, rather than by weakening the forecasting power

of the algorithm. The role of the volatility forecast is to provide the best projection
of volatility over the next trading period.
4 THE LINK BETWEEN MANAGED VOLATILITY AND TAIL RISK

We now turn to the impact of MV on the higher moments of the return distribution.
These outcomes are not captured by the traditional metrics of risk-adjusted returns
based on the first two moments: average return and volatility. In Section 5, we will
see that evaluating tail-risk properties presents a bridge to a more holistic perspective
on MV investor benefits.
Table 3 summarizes the key tail-risk metrics of the same MV strategies and sam-
ple/holding periods underlying the analysis in Table 1. We start by showing the third
and fourth standardized moments of the return distribution: skewness and kurtosis.
Skewness measures the asymmetry of the return distribution, and kurtosis measures
the fatness of the tails. Investors naturally prefer high positive skewness and low kur-
tosis. Portfolio-level kurtosis indicates that MV consistently thins the tails at twenty-
and sixty-day holding periods. At these holding periods, the benchmark features
meaningful excess kurtosis, while MV essentially produces normal tails with kurtosis
close to 3. As holding periods increase, return distributions become more normal.15
However, the normalization can be seen at shorter holding periods for MV than for
the benchmark. Bootstrap confidence intervals include the number 3, starting with a
sixty-day holding period for MV, but not until one year for the benchmark.16 This
effect on shorter-term kurtosis is present in most periods of our sample (see the sec-
ond appendix, available online). With few exceptions, MV skew confidence intervals
tend to be narrower and closer to, or more likely to include, zero than the benchmark,
supporting the tendency of MV to normalize return distributions.
Table 3 also shows measures of absolute tail risk in the form of 5% and 1% con-
ditional value-at-risk (CVaR). These represent the average of the bottom 5% and
1%, respectively, of relevant holding period returns. MV features notable, but time-
period-dependent, improvements, roughly similar to the SR pattern in Table 1. We
must keep in mind, however, that absolute tail risk is also a function of the level
of volatility itself. As can be seen clearly in Table 1, MV strategies feature greater
absolute volatility as well as greater average returns at longer holding periods.17 The
15 This is the natural effect of the law of large numbers when aggregating returns over time,
producing increasingly normally distributed sums even if the individual returns are not normal.
16 A kurtosis value of 3 is consistent with a normal return distribution.
17 This is perhaps surprising since MV is calibrated to match the volatility of the benchmark, albeit
at daily frequency. We hypothesize that this is due to the asymmetric impact of volatility estimation
error on positioning. Since MV sets equity exposure inversely to volatility forecast, an underestima-

generally lower CVaR of MV strategies is thus remarkable, as it occurs against a

backdrop of having higher volatilities. If higher volatilities are also associated with
higher returns, these absolute tail-risk properties could be more attractive than it may
seem at first blush. We home in on this aspect by also showing a metric that divides
the annualized return by the size of the CVaR. This metric neutralizes the impact of
higher baseline volatility if that volatility is accompanied by higher returns, as would
be the case if the SR remains constant. For these metrics, Table 3 paints a picture of
robust superiority of MV strategies, regardless of time horizon or sample period. The
positive impact for longer holding periods is particularly noteworthy.18
What is the intuition for the robust tail-risk reduction emanating from MV strate-
gies? We can think of the long-term volatility process as a mixture of distributions,
with different distributions being in place at different times.19 According to this
model, the long-term return patterns exhibiting excess kurtosis and time-changing
volatility can result from this mixture of short-term distributions, each with their
own inherent volatility. The most extreme observations are generated when con-
ditional volatility is high, and they appear abnormally large relative to the overall
volatility of the sample because low- or mid-level-volatility episodes dominate the
sample. At the same time, these events are not abnormal when viewed against the
conditional distribution that produced them at the time. Fat tails (fourth moment)
are merely a byproduct of conditionally elevated volatility (second moment). Due
to the short-term persistence of these different volatility regimes, the conditional
level of volatility is forecastable. By adjusting exposure inversely to the conditional
expectation of volatility, the MV strategy effectively normalizes the overall return
distribution, since essentially all portfolio returns are now drawn from roughly the
same distribution. In essence, the same phenomenon that causes fat tails, volatility
clustering, is also the key feature by which we can predict volatility and use MV to
remove fat tails from the return stream. This inherent linkage explains the robust-
ness of the kurtosis improvement. The pattern of volatility regularization shown in
Figure 1, which many investors seem to find intuitively preferable, is directly tied to
tion of true volatility adds more to portfolio risk than an overestimation by the same amount would
detract. From an investor perspective, the volatility gap between benchmark and MV should not be
too much of a concern per se, as one can directionally calibrate the MV strategy to a lower ex-ante
volatility profile in order to compensate for the impact of forecast error on realized volatility.
18 Upon examining these cases, it seems that skewness improvements can play a role here, even
when kurtosis is not reduced compared with the benchmark. Clearly, for the same level of kurtosis,
a larger skew can improve the CVaR, as more of that tail now resides in the positive return extreme
which the CVaR does not capture.
19 See Press (1967), Praetz (1972) and Clark (1973) for early work on this mixture of distribution
hypothesis.

44
TABLE 3 Tail-risk properties of benchmark (BM) and MV strategies evaluated over discrete windows with varied holding periods. [Table
continues on next two pages.]

‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ

1929–2018
Skewness 0.02 1.32 0.14 0.21 0.87 0.28 0.14 1.15 0.12 1.42 0.58 0.94
90% CI of [ 0.5,0.4] [ 2.5, 0.5] [ 0.6,0.7] [ 0.3, 0.1] [ 0.3,1.6] [0.1,0.4] [ 0.5,0.2] [0.5,1.5] [ 0.2,0.5] [0.5,1.7] [ 0.4,1.0] [ 0.1,1.4]
skewness
Kurtosis 18.25 26.71 10.88 3.99 13.16 3.43 3.94 6.14 3.02 5.70 2.72 2.85
90% CI of [13.0,24.1] [7.6,57.5] [6.8,13.6] [3.6,4.4] [5.7,15.9] [3.0,3.8] [3.2,4.4] [3.4,7.5] [2.4,3.5] [2.9,7.0] [1.5,3.4] [1.4,4.0]
kurtosis
5% CVaR 2.54% 2.54% 11.70% 11.73% 19.52% 17.60% 34.81% 31.23% 37.90% 37.13% 19.13% 21.23%
90% CI of [ 0.1%,0.4%] [ 0.2%,3.4%] [1.3%,7.3%] [1.1%,11.7%] [ 4.9%,5.8%] [ 11.3%,12.6%]
5% CVaR
difference
1% CVaR 4.36% 4.20% 18.32% 16.63% 27.78% 23.07% 48.83% 38.38% 47.54% 43.68% 19.13% 21.23%
90% CI of [ 0.1%,0.1%] [ 0.8%,0.8%] [0.0%,3.9%] [ 1.0%,7.1%] [ 5.5%,4.9%] [ 7.2%,12.6%]
1% CVaR
difference
Mean/ 1.13% 1.44% 5.03% 6.63% 9.26% 13.57% 21.48% 33.18% 69.99% 97.72% 262.77% 836.00%
( 5% CVaR)

Mean/ 0.66% 0.87% 3.22% 4.68% 6.55% 10.40% 15.58% 27.18% 58.06% 84.10% 262.77% 836.00%
( 1% CVaR)
TABLE 3 Continued.
‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ
1960–2018
Skewness 0.53 0.56 0.65 0.21 0.47 0.11 0.43 0.03 0.01 0.41 0.13 0.29
90% CI of [ 1.2,0.1] [ 0.8, 0.4] [ 0.9, 0.3] [ 0.3, 0.1] [ 0.7, 0.1] [ 0.1,0.3] [ 0.7, 0.1] [ 0.2,0.2] [ 0.3,0.4] [0.0,0.7] [ 0.6,0.6] [ 0.4,0.7]
skewness
Kurtosis 18.87 6.69 6.27 3.32 4.89 3.18 3.12 2.75 2.76 3.03 2.25 1.99
90% CI of [10.7,30.4] [5.1,8.9] [4.8,7.5] [3.2,3.5] [4.0,5.5] [2.9,3.4] [2.5,3.7] [2.4,3.1] [2.2,3.5] [2.3,3.5] [1.2,2.8] [1.2,2.7]
kurtosis
5% CVaR 2.28% 2.25% 10.38% 10.64% 16.92% 16.00% 28.56% 27.94% 33.70% 36.69% 17.11% 22.69%
90% CI of [0.1%,0.7%] [ 0.2%,4.2%] [ 0.5%,7.8%] [ 7.5%,7.0%] [ 7.3%,3.6%] [ 15.0%,9.2%]
5% CVaR
difference
1% CVaR 3.85% 3.45% 16.00% 14.07% 25.08% 21.11% 34.55% 33.18% 33.70% 36.69% 17.11% 22.69%
90% CI of [0.0%,0.1%] [ 1.1%,0.6%] [ 1.0%,3.0%] [ 5.6%,7.2%] [ 7.3%,3.6%] [ 13.5%,9.2%]
1% CVaR
difference
Mean/ 0.01% 0.01% 0.05% 0.06% 0.09% 0.12% 0.23% 0.29% 0.58% 0.63% 1.85% 3.72%
( 5% CVaR)
Mean/ 0.01% 0.01% 0.03% 0.04% 0.06% 0.09% 0.20% 0.24% 0.58% 0.63% 1.85% 3.72%

( 1% CVaR)

45
46
TABLE 3 Continued.
20 days 60 days 240 days 720 days

1 day (1 month) (3 months) (1 year) (3 years)
‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ
BM MV BM MV BM MV BM MV BM MV

1990–2018
Skewness 0.15 0.55 0.67 0.16 0.67 0.07 0.74 0.17 0.43 0.03
90% CI of [ 0.5,0.3] [ 0.7, 0.4] [ 1.0, 0.2] [ 0.3,0.0] [ 1.1, 0.1] [ 0.1,0.2] [ 1.0, 0.3] [ 0.4,0.6] [ 0.9,0.3] [ 0.7,0.7]
skewness
Kurtosis 11.33 5.99 6.47 3.09 5.59 2.69 3.67 3.01 2.30 2.48
90% CI of [8.9,13.7] [5.1,7.0] [5.0,7.6] [2.8,3.3] [3.7,6.8] [2.4,2.9] [2.4,4.7] [2.2,3.9] [1.6,3.0] [1.6,3.3]
kurtosis
5% CVaR 2.63% 2.58% 10.42% 9.33% 16.83% 13.72% 28.08% 23.51% 29.87% 32.85%
90% CI of [ 0.1%,0.7%] [1.1%,6.7%] [0.2%,12.8%] [ 2.3%,12.2%] [ 7.5%,11.0%]
5% CVaR
difference
1% CVaR 4.36% 4.02% 15.91% 12.02% 23.25% 16.20% 33.07% 25.56% 29.87% 32.85%
90% CI of [ 0.1%,0.2%] [0.0%,2.3%] [ 0.2%,7.8%] [ 2.5%,10.3%] [ 7.5%,11.0%]
1% CVaR
difference
Mean/ 0.01% 0.02% 0.06% 0.09% 0.12% 0.18% 0.31% 0.44% 0.94% 1.17%
( 5% CVaR)
Mean/ 0.01% 0.01% 0.04% 0.07% 0.09% 0.15% 0.27% 0.41% 0.94% 1.17%

( 1% CVaR)
the normalization of the distribution. These characteristics are two sides of the same
coin and should be viewed as one and the same benefit. MV will not produce one
without the other.
Last, because negative skewness and excess kurtosis reduce compound returns,
strategies like MV that normalize the return distributions should increase the com-
pound return. However, leverage is necessary to achieve return normalization with-
out degrading the long-term risk-adjusted return. Reducing the underlying exposure
during periods of high volatility normalizes the left tail, while increasing leverage
in low-volatility environments provides sufficient excess returns to compensate for
reducing risk (and return) in high-volatility episodes.
5 UTILITY PERSPECTIVE
We have demonstrated that while MV strategies provide robust tail-risk enhance-
ments, traditional evaluation of risk-adjusted return does not adequately reward this
property. Recall from Section 3 that the MV enhancement as measured by SR varies
across samples. Utility functions are a natural alternative, enabling us to evaluate
the shape of the return distribution, including tails. A key reference point is Goetz-
mann et al (2007), in which it is demonstrated that traditional performance metrics
such as SR can be “gamed” by investment managers using information-free (or non-
value-additive), static or dynamic trading strategies, such as selling options. Such
strategies can enhance SR by introducing unattractive higher moments that are not
penalized by that metric. The authors demonstrate that a manipulation-proof perfor-
mance measure (MPPM) must inherently take the form of a time-separable power
utility function in order to be robust to such manipulation while preserving the abil-
ity to reward genuine investment value-add. Our tail-risk-enhancing MV strategy
presents something of a mirror image of the manipulation problem in that its abil-
ity to remove unattractive higher moments from the distribution is not adequately
or consistently rewarded by traditional performance measures. Like the authors in
the MPPM paper, we choose to employ the constant relative risk aversion (CRRA)
utility function as a functional form that is widely used, easily calculated and inter-
pretable, and which satisfies the MPPM conditions. Its use in the well-known Morn-
ingstar scoring system for mutual funds is an important practitioner endorsement
of this approach (see Morningstar 2009).20 The CRRA utility function implies that
investors are tail-risk averse. All else being equal, they prefer investments with thin-
ner tails for a distribution with the same mean and volatility. Likewise, investors are
20 Dopfel and Ramkumar (2013) also provide a careful illustration of applying utility to MV
strategies, but their ultimate application differs from ours in some key aspects.

48
TABLE 4 Certainty equivalent metrics with different risk-aversion coefficients for benchmark (BM) and MV strategies evaluated over
discrete windows with varied holding periods. [Table continues on next two pages.]

‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ
1929–2018
CEV ŒRA D 1 4.50% 6.54% 4.25% 6.00% 4.09% 5.85% 3.78% 5.35% 4.48% 5.71% 5.23% 6.37%

Difference in CEV ŒRA D 1 2.05% 1.75% 1.76% 1.57% 1.23% 1.15%
90% CI of CEV ŒRA D 1 [0.1%,3.8%] [0.2%,3.2%] [0.2%,3.4%] [0.1%,3.1%] [0.1%,2.6%] [0.2%,2.8%]
difference
CEV ŒRA D 3 2.33% 3.73% 2.08% 2.94% 1.96% 2.79% 1.75% 2.38% 2.44% 2.74% 3.35% 3.46%
90% CI of CEV ŒRA D 3 [0.0%,3.7%] [ 0.5%,2.7%] [ 0.5%,2.8%] [ 0.4%,4.0%] [ 0.9%,3.0%] [ 0.4%,1.7%]
difference
CEV ŒRA D 5 1.54% 2.47% 1.37% 1.91% 1.29% 1.80% 1.14% 1.52% 1.67% 1.77% 2.38% 2.31%
90% CI of CEV ŒRA D 5 [ 0.6%,3.7%] [ 1.4%,2.2%] [ 1.1%,3.3%] [ 0.8%,7.0%] [ 1.4%,3.6%] [ 0.5%,1.3%]
difference
CEV ŒRA D 7 1.16% 1.85% 1.02% 1.41% 0.96% 1.33% 0.84% 1.12% 1.27% 1.30% 1.85% 1.74%
90% CI of CEV ŒRA D 7 [ 1.7%,3.4%] [ 2.1%,2.1%] [ 1.4%,4.5%] [ 0.8%,10.3%] [ 1.7%,3.9%] [ 0.6%,1.1%]
difference

CEV ŒRA D 10 0.84% 1.34% 0.74% 1.01% 0.69% 0.95% 0.60% 0.79% 0.93% 0.93% 1.40% 1.28%
90% CI of CEV ŒRA D 10 [ 4.3%,3.5%] [ 3.2%,2.5%] [ 1.4%,7.7%] [0.1%,12.8%] [ 1.9%,4.0%] [ 0.7%,1.1%]
difference
TABLE 4 Continued.

‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ
1960–2018
CEV ŒRA D 1 4.05% 5.05% 4.04% 4.76% 4.04% 4.79% 3.94% 4.65% 3.92% 4.42% 3.57% 3.74%
90% CI of CEV ŒRA D 1 [ 0.9%,2.9%] [ 1.0%,2.3%] [ 0.8%,2.4%] [ 0.9%,2.5%] [ 0.8%,2.0%] [ 0.4%,1.2%]
difference
CEV ŒRA D 3 2.14% 2.84% 2.08% 2.33% 2.06% 2.33% 1.97% 2.16% 2.19% 2.21% 2.31% 2.10%
90% CI of CEV ŒRA D 3 [ 0.9%,2.9%] [ 1.6%,1.8%] [ 1.5%,2.1%] [ 2.1%,2.5%] [ 1.4%,1.6%] [ 0.7%,0.6%]
difference
CEV ŒRA D 5 1.42% 1.89% 1.38% 1.51% 1.36% 1.51% 1.31% 1.39% 1.50% 1.44% 1.68% 1.45%
90% CI of CEV ŒRA D 5 [ 1.0%,2.9%] [ 2.3%,1.7%] [ 2.1%,2.5%] [ 3.3%,3.4%] [ 1.9%,1.3%] [ 0.9%,0.3%]
difference
CEV ŒRA D 7 1.06% 1.41% 1.03% 1.12% 1.02% 1.11% 0.98% 1.02% 1.14% 1.07% 1.32% 1.12%
90% CI of CEV ŒRA D 7 [ 1.0%,3.0%] [ 2.8%,1.8%] [ 2.8%,3.7%] [ 4.3%,4.7%] [ 2.3%,1.3%] [ 0.9%,0.2%]
difference

CEV ŒRA D 10 0.77% 1.02% 0.74% 0.80% 0.74% 0.80% 0.71% 0.73% 0.84% 0.77% 1.02% 0.84%
90% CI of CEV ŒRA D 10 [ 0.9%,3.3%] [ 3.4%,3.2%] [ 3.0%,6.6%] [ 5.3%,5.7%] [ 2.5%,1.0%] [ 1.1%,0.2%]
difference

49
50
TABLE 4 Continued.

‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ ‚ …„ ƒ
1990–2018
CEV ŒRA D 1 5.38% 7.18% 5.86% 7.59% 5.93% 7.64% 5.90% 7.42% 5.33% 6.31% 4.56% 5.23%

90% CI of CEV ŒRA D 1 [ 1.5%,4.9%] [ 0.6%,4.1%] [ 0.7%,4.5%] [ 0.7%,3.0%] [ 1.2%,4.1%]
difference
CEV ŒRA D 3 2.85% 4.14% 3.42% 4.65% 3.46% 4.74% 3.31% 4.22% 3.09% 3.25% 4.07% 4.36%
90% CI of CEV ŒRA D 3 [ 1.3%,4.8%] [ 1.0%,4.0%] [ 1.2%,4.9%] [ 1.2%,4.0%] [ 2.2%,4.0%]
difference
CEV ŒRA D 5 1.89% 2.74% 2.31% 3.10% 2.36% 3.17% 2.25% 2.77% 2.16% 2.13% 3.84% 3.97%
90% CI of CEV ŒRA D 5 [ 1.2%,4.4%] [ 1.2%,4.0%] [ 1.5%,6.5%] [ 1.7%,6.0%] [ 2.8%,4.3%]
difference
CEV ŒRA D 7 1.42% 2.05% 1.75% 2.33% 1.79% 2.38% 1.71% 2.06% 1.68% 1.58% 3.69% 3.73%
90% CI of CEV ŒRA D 7 [ 1.6%,4.7%] [ 1.5%,5.1%] [ 1.9%,9.0%] [ 2.2%,8.2%] [ 3.1%,4.4%]
difference

CEV ŒRA D 10 1.03% 1.49% 1.28% 1.69% 1.31% 1.73% 1.26% 1.49% 1.26% 1.14% 3.55% 3.52%
90% CI of CEV ŒRA D 10 [ 1.6%,4.6%] [ 1.7%,7.2%] [ 2.3%,14.8%] [ 2.8%,10.1%] [ 3.2%,4.6%]
difference
skewness seeking in that they prefer more positive skewness to less: again, all else
being equal.21 The CRRA utility function is conveniently parameterized solely by
the degree of risk aversion. As described in the first appendix (available online),
it is useful to convert the resulting expected utility into its certainty equivalent
(CEV): the certain return that is associated with the same expected utility as the
risky return.22
Our application of utility scoring reflects the use case of an asset manager who
offers mutual funds to a wide range of investors. Unlike an advisor working with
individual investors, the manager will not be aware of their individual preferences
and will have no opportunity to optimize directly to those preferences. Rather, the
manager needs to present a wide range of investment strategies at various risk levels,
appealing to investors with different degrees of risk aversion. Specifically, we start
with the daily MV and benchmark returns and create a range of possible portfolios
as simple multiples of each return stream over the [0:05, 0:1; : : : ; 0:95, 1:00] range.
From the perspective of the benchmark series, this amounts to simply providing a
range of fixed equity exposures between 5% and 100% (the benchmark itself), with
the remainder sitting in cash. Since the MV strategy is calibrated to the daily bench-
mark volatility, we apply the same set of multiples to create an MV series of differ-
ent risk levels. We now have twenty daily portfolios for each series, which we then
aggregate to the same longer-term holding periods as used previously. Each generic
CRRA investor with a given risk aversion and evaluation horizon/holding period now
has two series of twenty portfolios each from which to choose. We assume that the
investor chooses the preferred, utility-maximizing version from each series, with the
benefit of hindsight.23 We then compare the attained maximum utility within each
series via their CEVs.
Table 4 summarizes our results for utility metrics, using the same data as shown
in Tables 1 and 3. We show the CEV separately for MV and the benchmark. The
CEVs are calculated and annualized in such a manner that they can be interpreted in
terms of annual returns (see the first appendix (available online) for a more detailed
explanation of this calculation). MV CEVs are unambiguously greater than the cor-
responding benchmark CEVs for all three periods, and for all but the longest holding
21 See Ejara (2016) for a deeper and more technical discussion of the use of CRRA when higher
moments are present.
22 Maillard (2013) builds on the results of the MPPM paper by quantifying the CEV reduction
attributable to strategies with negative skewness and kurtosis that is reflected in the CRRA utility
but not captured in traditional performance metrics.
23 Our focus is on evaluation under utility criteria. How an investor might successfully identify the
utility-maximizing version prospectively is a separate problem, and one that we do not address.

periods.24 This finding dovetails with the groundwork laid in the previous section,
based on tail-risk metrics. Since CRRA utility rewards not only risk-adjusted returns
but also skewness and kurtosis, and since fatter tails feature more predominantly at
shorter holding periods, the CEV improvement is also greatest for shorter holding
periods. We suspect that MVs’ impact on skewness contributes as well. As shown
in Table 3, MV can enhance positive skewness, including for some of the longer
holding periods.
It is also worth noting that the absolute size of the improvements is economically
meaningful. For example, using the full sample and a conventional risk aversion (RA)
of RA D 3, the improvements in the CEV are in the range 0.29% (720 days/three
years) to 0.85% (twenty days/one month) per annum. These can be interpreted as the
additional cost, for example, in terms of trading costs or fees, that the investor would
be willing to incur with MV to render them indifferent to either the benchmark or
MV. Any cost lower than that would lead them to prefer MV.
Bootstrap confidence intervals for the differences in CEV between MV and the
benchmark are also shown. The utility improvement of MV relative to the bench-
mark is statistically significant only for the shortest holding periods. This is per-
haps surprising but can be put into perspective. The utility improvement of MV
over the benchmark in the historical sample likely results from outperformance dur-
ing extreme tail scenarios. These tail scenarios, by definition, occur infrequently,
and would not appear in all, or even most, of the bootstrap samples. Therefore, to
require purely positive confidence intervals for a tail-risk-hedging strategy repre-
sents an extraordinarily high bar. Rather, a lower and more reasonable hurdle for
robust improvement could be whether the investor is better off in the majority of
scenarios, as indicated by the average utility improvement of MV versus the bench-
mark. In the third appendix (available online), we illustrate that these economically
meaningful differences are also robust to transaction costs.
Finally, we illustrate the magnitude of the improvement in Figure 3. Here, we
contrast these CEV improvements with the SR improvements in Table 1. The CEV
improvement is larger across holding periods than the SR improvement: it is in the
30–60% range for up to one-year (240-day) holding periods, compared with the
SR improvement of only about 5–25%. Finally, the improvement holds across risk-
aversion assumptions. This lens is also more robust from an MPPM perspective and
captures an important penalty for fat tails that the SR metric misses.
24The CEVs generally decline with increasing risk aversion. This decline occurs because investors
with higher risk aversion typically select CEV-maximizing portfolios with lower risk and lower
returns.

FIGURE 3 Percentage improvement of MV over the benchmark for the data sample
starting in 1929, based on the SRs shown in Table 1 and the CEVs shown in Table 4.
70
SR
CEV [RA = 1]
60
CEV [RA = 3]
Improvement from MV over benchmark (%)
CEV [RA = 5]
50 CEV [RA = 7]
CEV [RA = 10]
40
30
20
10
–10
–20
1 20 60 240 720 2400
Holding period (days)
6 CONCLUSION
At the heart of so-called MV strategies lies a well-established and tantalizingly robust
feature of financial markets: risk, as measured by volatility, is a time-variant feature
of the return distribution, and unlike the expected return, a meaningful share of its
time variation is forecastable by a surprisingly simple extrapolation of recently expe-
rienced volatility. Since the trade-off between risk and return is arguably the most
fundamental concept of investment science, it is no surprise that MV has emerged
as an investment framework. This framework capitalizes on risk forecastability by
adjusting risk exposures inversely with predicted volatility in order to stabilize or
manage the portfolio-level risk across time.
Our paper fills a gap in the literature by establishing stylized facts for historical
MV performance by emphasizing the role of time. We use a very long-term series
of US market returns, which enables us to probe for robustness along the dimension
of historical periods, and we explicitly condition our results on holding periods. Our
main conclusion is that MV strategies should be thought of in terms of their ability
to mitigate tail risk first, rather than predominantly in terms of their potential for

enhancements to risk-adjusted returns. For investor–practitioners who need to cali-

brate their own expectations toward MV, this distinction is critical. We establish the
following stylized facts.
(1) When considering returns or SRs, MV enhances outcomes over the buy-and-
hold benchmark, on average, but with variation in the sizing of the enhance-
ments with holding period and across different starting historical periods.
(2) MV strategies remove fat tails (kurtosis) from the portfolio return as well as
enhancing skewness. The return normalization feature of reducing kurtosis is
inherently linked to the nature of the volatility stabilizing mechanism.
(3) When employing a utility framework to evaluate and compare MV strategies

with the benchmark, the improvements in terms of the CEV are economically
meaningful and show a larger relative improvement than those based on SRs.
This evaluation framework also reflects the source of tangible value-add from
MV strategies.
We encountered a number of areas that would benefit from additional research.

Since MV strategies adjust equity market exposure in response to predicted volatil-
ity, they have an important connection to the literature on conditional equity market
SRs. Much of this literature is dated earlier and focuses on business-cycle metrics for
conditioning. Our sense is that more work can be done in terms of SRs conditional
on predicted volatility, especially in terms of robustness to index and asset class,
historical period, and holding period. Any robust conclusion on the pro- or counter-
cyclicality of market SRs with respect to predicted volatility will naturally flow down
to the merits of MV strategies that trade on those volatility predictions. Implemen-
tation considerations are a second area where much work is still left to be done. For
investors who do measure performance against a buy-and-hold benchmark, MV can
quickly introduce large amounts of tracking error to this benchmark, especially when
using short-term forecasts that tend to work best for near-term volatility estimation.
We believe that investment managers and applied researchers owe investors more
thoughtful guidance on how to choose the “right-sized” exposure to MV strategies
when a benchmark tracking error is being considered.
DECLARATION OF INTEREST
The authors report no conflicts of interest. The authors alone are responsible for the
content and writing of the paper. This article is distributed under the terms of the
Creative Commons Attribution 4.0 International License, https://creativecommons
.org/licenses/by/4.0/.

ACKNOWLEDGEMENTS
T. Rowe Price has extensively researched MV for more than ten years and has
implemented this investment approach for clients within internal and external strate-
gies since December 2014. MV strategy solutions are proactively offered to suit-
able clients by qualified T. Rowe Price associates and are tailored by the multiasset
investment team for client-specific objectives and constraints.
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Tail-Risk Mitigation With Managed Volatility Strategies: Research Paper

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Journal of Investment Strategies 8(1), 29–56

Tail-risk mitigation with managed volatility

T. Rowe Price, 100 E. Pratt Street, Baltimore, MD 21202, USA;

(Received November 7, 2018; accepted February 21, 2019)

Keywords: managed volatility (MV); tail-risk mitigation; return distribution normalization;

Corresponding author: A. A. Dreyer Print ISSN 2047-1238 j Online ISSN 2047-1246

Electronic copy available at: https://ssrn.com/abstract=3074529

Journal of Investment Strategies www.risk.net/journals

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2 WHY MIGHT MANAGED VOLATILITY BE WORTH HAVING?

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calculation details), the return correlation between adjacent sixty-trading-day peri-

Journal of Investment Strategies www.risk.net/journals

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4The illustrated strategy is unconstrained and rebalanced daily.

Journal of Investment Strategies www.risk.net/journals

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note that MV strategies – as we define them – constitute an actual investment cat-

3 TRADITIONAL RISK-ADJUSTED PERFORMANCE EVALUATION

if cash is used as the de-risking asset to avoid asset allocation effects.

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1940 1950 1960 1970 1980 1990 2000 2010

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Benchmark 2.71 11.65 19.36 39.00 72.49 111.76

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constraints on portfolio construction, rather than by weakening the forecasting power

4 THE LINK BETWEEN MANAGED VOLATILITY AND TAIL RISK

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generally lower CVaR of MV strategies is thus remarkable, as it occurs against a

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