A widely held belief among investors is that volatility is predictable, which is why it plays a crucial role in many investment and risk management strategies. The thinking goes that if volatility can be accurately predicted, investors may be able to position portfolios to better capture the gains that can accompany upside volatility and better mitigate the losses that can occur from downside volatility.
The goal: Stronger risk-adjusted returns over time.
As such, what is a useful method to predict volatility in a reliable and consistent way over time?
Our research-based white paper, How Effective is Volatility Forecasting in Equity Markets?, examines how volatility forecasting can enhance value for the portfolio management process, and studies an effective approach for predicting that volatility.
We studied the closing prices of the nine S&P 500 sector ETFs, that date back as far as December 23rd, 1998, from their inception dates through June 28th, 2016. This evaluation period encompassed multiple market cycles, including the tech bubble of the early 2000s and the mortgage crisis and recovery of 2007-2009.
Based on our analysis, we arrived at the following key conclusions:
- Looking to the future beats looking in the rearview mirror. Investors have heard the phrase “past performance is not indicative of future results,” but volatility can be different. It turns out that forecasts of future volatility predict actual realized volatility more accurately than do measures of historical volatility. This is true over both short- and medium-term horizons (one- and two-month periods).
- The accuracy of volatility forecasts rise along with realized volatility. The advantages of using future volatility forecasts instead of historical volatility measures actually increase as the market becomes more turbulent and securities become more volatile.
- Volatility forecasting can add value to portfolio management results. These results suggest that volatility forecasting can be a useful tool in the process of selecting individual equities for portfolios and in the process of managing portfolio risk.
The research also points to five reasons why volatility forecasting results in more accurate predictions of future volatility levels.
Conclusion: Investors should not be concerned with what volatility was in the past, but rather with what volatility is likely going to be in the future.