With this simple single asset example as a backdrop, let’s turn our attention to applying volatility targeting on a multi-asset portfolio. For the purposes of this analysis, we will use the Research Affiliates Global Multi-Asset Index (RAGMAE)5. The Research Affiliates Global Multi-Asset Index is a 5% volatility targeted multi-asset index combining futures exposure to 226 global equity markets, global government bonds and commodities, incorporating native diversification into the portfolio. The assets are combined using a set of both strategic/secular and tactical signals and wrapped in a custom volatility targeting framework. The base strategic portfolio utilizes Research Affiliates capital market expectations to ground the positions in forward looking expectations based on where assets are priced to go, not where they’ve been in the past7. On top of the strategic allocations are tactical over- and underweights based on the carry, value and trend momentum of the various assets. Utilizing these robust signals allows the index to capture shorter-term pricing opportunities that surround the secular trajectory of asset markets.
The RAGMAE index also improves upon simple volatility targeting using a unique multi-step approach. Similar to the simple single asset approach, we determine leverage and position sizes based on expected volatility. However expected volatility can be noisy and slow to adjust to very rapid changes in volatility. The RAGMAE index also adjusts leverage based on realized short-term volatility. The index uses a tail risk management approach where positions are liquidated and moved to cash if realized short-term volatility is greater than 7%. This is done in an effort to get ahead of major market selloffs.
The below table highlights the impact of the strategic, tactical and volatility targeting components of the index. The strategic and tactical components have provided returns of 4.3% and 2.5%, respectively, over the course of our simulation, while the volatility targeting detracted 0.3%. As mentioned earlier, the goal of volatility targeting is not enhanced returns, but rather to provide a more stable ride over time.