Smoothing volatility targeting

Abstract

We propose an alternative approach towards cost mitigation in volatility-managed portfolios based on smoothing the predictive density of an otherwise standard stochastic volatility model. Specifically, we develop a novel variational Bayes estimation method that flexibly encompasses different smoothness assumptions irrespective of the persistence of the underlying latent state. Using a large set of equity trading strategies, we show that smoothing volatility targeting helps to regularise the extreme leverage/turnover that results from commonly used realised variance estimates. This has important implications for both the risk-adjusted returns and the mean-variance efficiency of volatility-managed portfolios, once transaction costs are factored in. An extensive simulation study shows that our variational inference scheme compares favourably against existing state-of-the-art Bayesian estimation methods for stochastic volatility models.