Volatility and the asset allocation decision

Schwalbach, Joao Bruno
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This dissertation investigates the inclusion of volatility into the asset allocation decision, first as an asset class, and second as a tool for dynamic equity allocation. An examination on whether volatility exposure as an asset class has the necessary characteristics to form part of the broader investment universe is conducted. This is accomplished by comparing the risk-return characteristics of three naked option-selling strategies, a bull put spread strategy and a VIX futures strategy with the S&P 500 Index. Each volatility strategy is also included as part of a 30/30/40 volatility/equity/bond portfolio and compared to a traditional 60/40 equity/bond portfolio. Historically, the results indicate that all individual volatility strategies generated superior Sharpe ratios and exhibited less severe drawdowns than the S&P 500 Index, particularly during the 2008 Global Financial Crisis. Additionally, all volatility blended portfolios experienced better tail-risk profiles than the 60/40 equity/bond portfolio, with the naked option-selling strategies also generating similar returns as the 60/40 portfolio both over the full sample period as well during the period of recovery following the 2008 Global Financial Crisis. The results suggest that the returns associated with option-selling strategies are consistent, and have resulted in strong long-run risk-adjusted performance, qualifying short volatility exposure attained through option-selling strategies as an asset class. It however remains unclear whether the VIX futures strategy qualifies as an asset class given that it aims to exploit a market anomaly in the form of potentially non-priced volatility clustering in the S&P 500 Index. While the strategy generated considerable outperformance from 2004 to 2009, it underperformed from 2009 to 2016 suggesting that much of the non-priced volatility clustering has since been traded away. Drawing on the evidence of volatility clustering in equity markets, a managed volatility trading rule that regulates portfolio exposure between cash and equity based on how high the prevailing volatility level was relative to historical volatility levels is developed. Although transaction costs were not accounted for, the results indicated that the managed volatility trading rule has historically generated considerably superior Sharpe ratios than equity in developed and developing markets. In conclusion, volatility exposure attained through option-selling strategies has proven to be an attractive asset class, and historical evidence suggests that its inclusion into a traditional 60/40 equity/bond portfolio is likely to reduce the risk of future risk-adjusted underperformance relative to what had been achieved in the past. Additionally, the managed volatility trading rule remains an attractive alternative to investors who are precluded from investing in volatility as an asset class.
Thesis (M.Com. (Finance))--University of the Witwatersrand, Faculty of Commerce, Law and Management, School of Economic and Business Sciences, 2017
Schwalbach, Joao Bruno (2017) Volatility and the asset allocation decision, University of the Witwatersrand, Johannesburg, <https://hdl.handle.net/10539/24781>