Equity Bull Bias in Volatility Targeting

Frustrating. A sharp break in the market for stocks, diversifying assets (hedge funds, risk premia, risk parity, trend following, equity l/s) all down. What gives? In a word- Vol. In the hedge fund space, or more specifically the quant hedge fund space (which is responsible for bulk of trading flow today), trading in the short run is being dominated by reactions to changing vol. Whether you are risk parity, risk premia, trend following, equity l/s, momentum, value, carry, etc., the common theme is sizing positions based on vol. When vol is low, take bigger positions, when vol is high take smaller positions. So, what happens when equity markets break and vol spikes? Hedge funds “de-risk”, “de-lever”, “gross-down”, “vol-adjust”, “risk manage”- lots of names, all mean the same thing.

Think about it.  You invested in all those factors, methods, markets, using all manner of sophisticated quantitative methods, but they all get unwound at the same time. Irony is, it is the manager’s risk management that is creating systemic risk in your balanced portfolio.

To narrow this argument further, what does vol targeting mean for managed futures and systematic trend following, strategies that are supposed accept those “crash” flows when the equity market breaks. Vol targeting means taking larger positions when vol is low, and when is vol the lowest, during quiet equity bull markets (think early February 2018). Conversely, when equity markets are falling and volatility is spiking, vol targeting requires reducing positions. So even when they do get short stocks, they are not doing it in size. Put simply, your trend following manager has a bull bias to stocks, and reduced diversification benefit in a market sell-off. To the manager, this is tolerable as the overall return across the cycle will have a higher Sharpe ratio due to the increased leverage toward stocks during equity bull periods. In a portfolio context, however, the client has already made asset allocations to equity and other risk assets, what they really need is diversification, not Sharpe ratio.

At Mount Lucas, in our MLM Index, we do not subscribe to a vol targeting methodology for the reasons listed above, as well as a few others. One, volatility is only predictable till it isn’t, we have seen this time and time again in the market. Additionally, among all the technical indicators trend followers use to take positions, why would volatility ever be used as an indicator for the future profitability of a trade? Vol targeting means taking larger positions when vol is low, but does that mean positions have a greater probability of success simply because they have low vol? The answer is no.