Volatility as an Asset Class – A Valuable Portfolio Diversifier in Volatile Times?

Abstract

This article examines the feasibility of using
volatility as an asset class to diversify equity portfolios. Especially
exchange-traded volatility products targeted at retail investors
promise convenient but effective equity hedging. This study looks
under the surface of these seemingly simple products, and
backtests them in extensive portfolio diversification studies. We
apply a wide range of test settings, including different volatility
weights, product maturities, time periods, rebalancing patterns,
and dynamic allocation strategies while adopting the perspective
of U.S. equity investors over the volatile period from 2006 to
2011. We find that volatility exposures of up to 10%,
implemented through mid-term volatility products or with a
straightforward dynamic allocation strategy based on detecting
trends in implied volatility, would have benefited equity
portfolios in most scenarios.