This research paper explores how adjusting portfolio exposure based on market risk can improve long-term compounding and significantly reduce drawdowns.
Strategy Overview
The approach is simple in principle. When market volatility rises, exposure is reduced. When conditions calm down, exposure increases. The goal is to keep risk more stable over time rather than letting it fluctuate with the market.
In this study, a 10% volatility target is applied to SPY, with multiple forecasting methods tested, including GARCH, EWMA, realized volatility, and the proprietary NextVoL® framework.
Volatility Targeting Strategy Results
Backtesting across different market environments shows strong improvements in risk-adjusted performance:
- 320% total return (8.31% CAGR) using NextVoL®
- Sharpe ratio of 0.79, highest among tested models
- Maximum drawdown of ~19%, compared to ~52% for SPY
- Most consistent delivery of the target risk level
Why It Matters
Market volatility is not random. It tends to cluster, and periods of high volatility are often associated with weaker risk-adjusted returns.
By scaling exposure up and down through different regimes, this approach smooths the investment path and reduces the likelihood of large losses, making it easier to stay invested over the long term.
Conclusion
The volatility targeting strategy provides a structured way to manage risk without relying on return predictions. While it may reduce absolute returns compared to passive investing, it significantly improves risk-adjusted performance and portfolio stability.