Friday, May 25, 2012

Investing with a Target Volatility Approach

Since I mentioned one of my favorite ETP sites earlier today [the more I think about it, the more I have come around to the idea that the Best Post of the Year on Exchange-Traded Products may be the best post I have ever seen on the subject] I thought it might be a good idea to include some functionality with that required weekend reading.

Another superb ETP site, ETFreplay.com, recently launched a Volatility Target Backtest tool. What this tool is designed to do is to demonstrate what historical returns would have looked like if one had taken a high volatility ETP such as a leveraged ETP, a VIX-based ETP, etc. and combined with a dynamic cash allocation and historical volatility data to limit exposure to a target volatility ceiling.

An example may make this easier to visualize. Let’s assume that you are bullish on the Russell 2000 index of small capitalization stocks and want to get some long exposure to these stocks with the +2x leveraged ETP, ProShares Ultra Russell2000 (UWM). Last August, however, the 10-day historical volatility in UWM spiked over 160 and right now it is at 41 – and you decide those levels of volatility are unacceptable, particularly with all the uncertainty in Greece and across the euro zone.

The solution? How about a portfolio that dynamically allocates between UWM and cash, (here using the iShares Barclays 1-3 Year Treasury Bond, SHY), based on 10-day historical volatility data and targets a forward volatility level of 20%.

The graphic below shows the ETFreplay backtest results of such a portfolio, using a monthly rebalancing period and starting in January 2007, when UWM was launched.

Of course past results are no guarantee of how this type of strategy might work in the future (and leveraged ETPs certainly entail a great deal of compounding decay risk for long-term investors), but the graphic is compelling, for both bull and bear markets. Think of this type of approach as a way to fine-tune risky products to a desired volatility level.

Enjoy the long weekend, everyone!

Related posts:

[source(s): ETFreplay.com]

Disclosure(s): none

blog comments powered by Disqus
DISCLAIMER: "VIX®" is a trademark of Chicago Board Options Exchange, Incorporated. Chicago Board Options Exchange, Incorporated is not affiliated with this website or this website's owner's or operators. CBOE assumes no responsibility for the accuracy or completeness or any other aspect of any content posted on this website by its operator or any third party. All content on this site is provided for informational and entertainment purposes only and is not intended as advice to buy or sell any securities. Stocks are difficult to trade; options are even harder. When it comes to VIX derivatives, don't fall into the trap of thinking that just because you can ride a horse, you can ride an alligator. Please do your own homework and accept full responsibility for any investment decisions you make. No content on this site can be used for commercial purposes without the prior written permission of the author. Copyright © 2007-2013 Bill Luby. All rights reserved.
 
Web Analytics