I'm new and i'm starting studying finance. My english level is not so good. Could you explain me please, what is volatility timing?
Thanks to all
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$\begingroup$ Do you know what "volatility" is ? For ex. historical volatility or implied volatility. OK, volatility timing means to change the composition of your portfolio based on volatility $\endgroup$– nbbo2Commented Dec 14, 2017 at 18:41
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$\begingroup$ Ok thanks. Can you suggest me a book where i can learn more about it? $\endgroup$– SkillsCommented Dec 14, 2017 at 18:45
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1$\begingroup$ It is a new area so there are no books that I know. Only papers. One that I remember is Moreira: papers.ssrn.com/sol3/papers.cfm?abstract_id=2659431 There are 3 or 4 others I can mention later if you want. $\endgroup$– nbbo2Commented Dec 14, 2017 at 18:50
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$\begingroup$ A warm welcome to Quant.SE and thank you for your question. Please see my answer below: quant.stackexchange.com/a/37377/12 $\endgroup$– vonjdCommented Dec 15, 2017 at 10:51
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2 Answers
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Volatility timing lowers exposure to risky assets when volatility of recent returns for those assets is relatively high and raises exposure to risky assets when volatility of recent returns for those assets is relatively low. Contrary to conventional wisdom, this volatility-managed strategy e.g. sells during panics like the Great Depression and 2008.
Evidence indicates that weighting investments in risky asset portfolios by inverse volatility may enhance gross risk-adjusted performance (already mentioned in the comments by @noob2):
Moreira, Alan and Muir, Tyler, Volatility-Managed Portfolios (October 25, 2016). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2659431 or http://dx.doi.org/10.2139/ssrn.2659431
Abstract
Managed portfolios that take less risk when volatility is high produce large alphas, substantially increase factor Sharpe ratios, and produce large utility gains for mean-variance investors. We document this for the market, value, momentum, profitability, return on equity, and investment factors in equities, as well as the currency carry trade. Volatility timing increases Sharpe ratios because changes in factors' volatilities are not fully offset by proportional changes in expected returns. Our strategy is contrary to conventional wisdom because it takes relatively less risk in recessions and crises yet still earns high average returns. This rules out typical risk-based explanations and is a challenge to structural models of time-varying expected returns.
Summary (behind paywall):
https://www.cxoadvisory.com/28346/volatility-effects/varying-risk-inversely-with-recentexpected-volatility/
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Broadly speaking "volatility timing" means adjusting your portfolio based on current (implied or historical) volatility.
This is a relatively new area of research, which developed a few years after the financial crisis when researchers discovered that reducing exposure during the crisis in response to increased volatility (and increasing it later as volatility calmed down) would have produced good results. Like all retrospective findings (or as my boss calls them "telling me today what I should have done yesterday" or "driving by looking in the rear view mirror") we should be a little skeptical whether it will produce equally good results in the future. Nevertheless it is an interesting area that has been fashionable and I recommend the three best papers in my opinion:
Moreira and Muir: Volatility-Managed Portfolios (2015) SSRN 2659431
Hallerbach: Advances in Portfolio Risk Control (2013) SSRN 2259041
Cooper: Alpha Generation and Risk Smoothing Using Managed Volatility (2010) SSRN 1664823
