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Recent COVID-19–related market turmoil has dramatically shown that the assumption of constant stock market volatility is far from reality. During these volatile times—the Chicago Board Options Exchange Volatility Index, the so-called fear index, hit an all-time closing high of 82.69 on March 16 which is approximately 4 times higher than its average level. Not accounting for those swings in market volatility and involved tail risks can have potentially catastrophic outcomes and can be so distressing that panic reactions are possible. Not only option implied volatility measures but also market returns-based volatility measures have exhibited sharp moves. For example, Exhibit 1 shows the realized volatility of the MSCI World Index1 during each of the 2,114 weeks between January 1, 1980 and June 30, 2020. The chart is dominated by three towering volatility spikes—the 1987 crash, the 2008 Global Financial Crisis, and the COVID-19 pandemic crisis of 2020—at which annualized volatility rose to levels around 100%, more than six times higher than the average volatility of 15%.2 Such events are felt as if, during that week, the allocation to equities were six times higher than the actual level. Three events in a little more than 40 years sets the probability of such events at around one event in every 10 to 15 years. Less cataclysmic, but still major, events happen when volatility doubles to above 30%. This happens approximately every 65 weeks, or, roughly speaking, between one and two times per year.3
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Although the aforementioned empirical facts are well known, many portfolio construction processes assume that volatility is constant, either explicitly or implicitly. Although this assumption is sensible on average, there is actually a huge deviation from this average over time. Hence, we revisit the advantages and disadvantages of managing portfolio volatility. This article will ask the following questions: What is the right volatility predictor for most asset classes? Is managing portfolio volatility possible? Is managing volatility economically beneficial in terms of risk-adjusted returns? How applicable is volatility management across asset classes?
It should be noted, of course, that the benefits of volatility-managed strategies are documented in seminal papers, some dating to nearly two decades ago, such as those by Fleming, Kirby, and Ostdiek (2001, 2003), and in more recent...