Swedroe: Volatility As A Strategy

August 02, 2017

With all 34 means being positive, and with 32 significant at the 1% level and two at the 10% level, Fallon, Park and Yu concluded: “This consistency suggests a reliable risk premium whose basis is the persistent excess of implied over realized volatility.”

They also concluded: “Equally consistent are the patterns in higher moments, with skewness values often large and negative and excess kurtosis figures large and positive. Taken together, these results indicate that buyers offer insurance-like economic rents to sellers, who earn a steady monthly income in exchange for bearing ‘crash’ risk—the possibility of severe but empirically infrequent losses.”

In other words, there is a trade-off between average returns and tail risk, with the worst cases being more than double the magnitude of the most-positive observations.

Patient Trading Critical

It’s important to note that Fallon, Park and Yu found that “on average, that transaction costs reduce gross returns by 47%, a significant reduction.” Thus, to successfully implement the strategy, patient trading is critical, as investors should want to be a seller, not a buyer, of liquidity. That means accepting tracking-error risk.

The authors also observed that the correlations between the GVCP and each of their volatility-return series indicate there is a possibility for diversification benefits across asset classes—pooling enhances the risk and reward trade-off. Correlations are higher in equities and currencies (composite correlations of 0.88 and 0.83) and lower in fixed income and commodities (composite correlations of 0.54 and 0.69).

They found that the Sharpe ratio of the GVCP—which pools by asset class and is the broadest composite—remains more than 31% higher than the average Sharpe ratio of the composites (1.02 versus 0.78) and 94% higher than the average Sharpe ratio across assets (1.02 versus 0.53). However, they found no improvement in tail risk.

They concluded: “Tail risk events in our sample are more highly correlated than typical month-to-month returns.”

Finally, Fallon, Park and Yu concluded that what the GVCP offers is largely distinct from the exposures of standard explanatory factors (market beta, size and value). The authors write: “Therefore, it may offer unique and additive diversification benefits to traditional portfolios.” The findings Fallon, Park and Yu present in their study are consistent with previous research.


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