BNY Mellon report questions long-term performance prospects of volatility targeting ETFs

Aug 7th, 2012 | By | Category: ETF and Index News

Investors should be cautious about the continued success of volatility targeting investment strategies, despite historical data that show such strategies would have added value in recent years, according to a report from BNY Mellon’s Investment Strategy & Solutions Group.

BNY Mellon report questions long-term performance prospects of volatility targeting ETFs

Equity volatility targeting investment strategies increase allocations to stocks during periods of low volatility and reduce allocations to stocks when volatility is high.

Volatility targeting investment strategies increase allocations to stocks during periods of low volatility and sell stocks when volatility is high.

As well as being a popular ploy of traditional active managers, volatility targeting has been embedded into a number of strategy-based indices created by providers such as S&P and Dow Jones and forms the basis of a range of volatility targeting ETFs.

The report, Volatility Targeting May Miss the Mark, notes that such volatility targeting strategies would have worked well over the last 20 years, but would have been far less successful over a longer time frame, such as the last 60 years.

“Considering only the recent period can make volatility targeting appear to be an attractive strategy, but investors are unlikely to find the strategies so rewarding in the future,” said Ralph Goldsticker, senior investment strategist for ISSG and the author of the report.  “Rather than mechanically trading based on the level of volatility, investors would be better off evaluating market fundamentals, both risk and return.”

Goldsticker said BNY Mellon’s Investment Strategy & Solutions Group has been studying the behaviour of volatility targeting investment strategies as the introduction and adoption of such strategies have gained momentum over recent years.

The report notes that the last 20 years were unusual, as stocks delivered high returns with low volatility during the 1990s.  This was followed by a decade of low returns and high volatility, the report said.  A volatility targeting strategy would have called for an above-average allocation to stocks during the 1990s bull market and a below-average allocation during the disappointing markets of the 2000s, ISSG said.  That strategy would have been highly successful, according to the report.

However, Goldsticker cautioned that investors must thoughtfully evaluate back-tested results.  “They are only relevant if the future will look like the past.  I do not believe that markets will repeat the pattern of the past 20 years, the period over which many of the strategies were tested.”

He continued, “Volatility was relatively high between 1973 and 1990.  The period started with a bear market, but stocks performed well for the rest of the period.  It’s just one example illustrating that the level of volatility is not necessarily linked to future market direction.”

Volatility is determined by the level of economic uncertainty and by the level of investor risk aversion, which determines how strongly markets react to events as they unfold.  Neither of these factors is systematically linked to subsequent market direction, according to the report.

The findings raise questions about the long-term performance prospects of funds tracking volatility targeting strategy benchmarks such as the S&P Risk Control Indices and the Dow Jones Volatility Risk Control Indexes.

In terms of exchange-traded products, Direxion launched three ETFs tracking S&P Dynamic Rebalancing Risk Control indices earlier this year, while ProShares has filed registration paperwork with the US Securities & Exchange Commission to launch a suite of seven ‘volatility target’ ETFs. Both Direxion and ProShares are US-based ETF providers specialising in alternative, leveraged and inverse products.

The Direxion ETFs include the Direxion S&P 1500 RC Volatility Response Shares (VSPR), the Direxion S&P 500 RC Volatility Response Shares (VSPY) and the Direxion S&P Latin America 40 RC Volatility Response Shares (VLAT). These funds are designed to be held long term and aim to deliver index equity exposure by following a dynamic, rules-based investment approach that uses volatility as a gauge to determine equity exposure – essentially, volatility targeting. As volatility increases, risk is mitigated by reducing exposure to equities and increasing exposure to Treasury Bills; correspondingly, as volatility decreases, exposure to equities is increased and exposure to Treasury Bills is decreased.

The launch date for the proposed ProShares Volatility Target ETFs is unknown.

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