This paper won the National Association of Active Investment Managers (NAAIM) 2010 Wagner Award for Advances in Active Investment Management.
It is difficult to predict stock market returns but relatively easy to predict market volatility. But volatility predictions don't easily translate into return predictions since the two are largely uncorrelated. We put forward a framework that produces a formula in which returns become a function of volatility and therefore become somewhat more predictable. We show that this strategy produces excess returns giving us the upside of leverage without the downside.
As a side-effect the strategy also smoothes out volatility variation over time, reduces the kurtosis of daily returns, reduces maximum drawdown, and gives us a dynamic timing signal for tilting asset allocations between conservative and aggressive assets.
volatility timing, volatility of volatility, extreme volatility, volatility drag, managed volatility, continuously dynamic leverage, leveraged exchange traded funds, alpha generation, kurtosis, maximum drawdown
The full and most up to date version of this paper is available at SSRN Alpha Generation and Risk Smoothing using Managed Volatility
The NAAIM Wagner Award winning (4 pages shorter) version of the paper is at Alpha Generation and Risk Smoothing using Volatility of Volatility
The Risk Professional Manazine version of the paper is a more digestible 7 page version and is available on the Quant Perspectives page at Alpha Generation and Risk Smoothing using Volatility of Volatility
CXO Advisory have a review of the strategies at Exploiting the Predictability of Volatility
Ron Rowland (Invest with an Edge) has some comments on the paper at The Volatility of Volatility