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

This article examines the feasibility of usingvolatility as an asset class to diversify equity portfolios. Especiallyexchange-traded volatility products targeted at retail investorspromise convenient but effective equity hedging. This study looksunder the surface of these seemingly simple products, andbacktests them in extensive portfolio diversification studies. Weapply a wide range of test settings, including different volatilityweights, product maturities, time periods, rebalancing patterns,and dynamic allocation strategies while adopting the perspectiveof U.S. equity investors over the volatile period from 2006 to2011. We find that volatility exposures of up to 10%,implemented through mid-term volatility products or with astraightforward dynamic allocation strategy based on detectingtrends in implied volatility, would have benefited equityportfolios in most scenarios