Is there an edge in volatility-managed portfolios? If so, where is it?

Sammanfattning

This paper examines whether volatility timing improves the risk-adjusted performance of factor portfolios and which characteristics drive cross-sectional variation in its effectiveness. Using 153 U.S. equity factor portfolios, volatility-managed portfolios are constructed by scaling exposure inversely with lagged realized variance and evaluate performance using Sharpe ratios and alphas. Volatility timing delivers modest improvements: Sharpe gains are small and insignificant, while alphas are more consistently positive. The main economic effect is reduced realized volatility rather than higher returns. The benefits vary across factors, with downside risk and return asymmetry emerging as key drivers. Factors with higher downside volatility, negative skewness, and greater tail risk benefit the most. In contrast, total volatility and volatility persistence have limited explanatory power. Overall, volatility timing improves efficiency by reducing exposure in adverse states, but its benefits are concentrated in factors with pronounced downside risk, highlighting the central role of downside risk in dynamic portfolio management.