Transcription

• Speaker #0

  Hello, welcome back to Papers with Backtest podcast. Today, we dive into another algo trading research paper.

• Speaker #1

  This one is about timing the low volatility factor. Yeah, timing volatility for potentially better returns.

• Speaker #0

  Okay, so we're not just buying and holding low volatility stocks here. We're trying to be a little bit smarter.

• Speaker #1

  Yeah. Imagine instead of just driving slow and steady all the time, you can, you know, speed up when the roads clear, and then you slow down when you see some potholes.

• Speaker #0

  OK, I like that analogy. So instead of just accepting low volatility stocks outperform, we're saying maybe there's a way to kind of supercharge that.

• Speaker #1

  Exactly. The researchers tested this idea using U.S. stock data from 1963 to 2016.

• Speaker #0

  Wow. So that's a pretty significant period. What did they discover? Did they find a way to time this effectively?

• Speaker #1

  Yeah, they came up with some pretty straightforward trading rules. It boils down to looking at the slope of the return profile for volatility decile portfolios.

• Speaker #0

  OK, so we're picturing all the stocks in the market from the least volatile to the most volatile.

• Speaker #1

  Yeah, like a big parade of volatility. All right. And the slope, it measures the difference in returns between like the highest volatility stocks and then the lowest volatility stocks.

• Speaker #0

  OK, so if the high volatility stocks are outperforming the low volatility stocks by a large margin, we're saying the slope is steep and positive.

• Speaker #1

  Right. That's our signal to jump into the high volatility portfolio. Right. When the market is doing well. you want to be in those high-flying stocks.

• Speaker #0

  Makes sense. But what about when things get a little shaky? What happens then?

• Speaker #1

  If the slope turns negative, meaning those low-volatility stocks are suddenly holding up better, that's our signal to shift gears into a more defensive position. We park our money in the low-volatility portfolio and wait for the storm to pass.

• Speaker #0

  So we're reading these signals from the market and we're adjusting our position based on these signals. But how do we know if the slope is significantly positive or negative? Are we just kind of eyeballing this?

• Speaker #1

  Not really. The researchers, they used a statistical test called a t-test.

• Speaker #0

  A t-test.

• Speaker #1

  Yeah. It helps us kind of filter out those random fluctuations and focus on the signals that really matter.

• Speaker #0

  Got it. So if our calculations show a t-statistic above a certain level, that's our green light to go for those high volatility stocks. And if it falls below a certain level on the negative side. That's our signal to switch to low volatility.

• Speaker #1

  Exactly. It's a pretty simple signal. You can run this calculation every month. You gather your data, you calculate your slope, you run your t-test, and then you just adjust your portfolio.

• Speaker #0

  I like that. It's very systematic. So tell me about the performance. Did the systematic approach actually work? Spill the beans. What are the backtest results?

• Speaker #1

  Okay. Well, the researchers tested several different variations of this strategy. The basic one was starting with a low volatility portfolio and switching to high volatility whenever that slope turns significantly positive.

• Speaker #0

  So you're always in one of the two extremes, either low volatility or high volatility. What happened there?

• Speaker #1

  Well, it outperformed a static low volatility portfolio.

• Speaker #0

  OK, so it's doing something.

• Speaker #1

  But the volatility of the strategy also increased.

• Speaker #0

  Oh, so more potential for gains, but also more potential for, you know, excitement.

• Speaker #1

  Right. The classic risk reward tradeoff. Right. And the Sharpe ratio is actually a little bit lower than just holding low volatility stocks.

• Speaker #0

  Okay. So maybe always defaulting to low volatility isn't the best approach. What about starting with a middle, a mid volatility portfolio?

• Speaker #1

  So instead of going from one extreme to the other, you start in a more balanced position. Yeah. They call that the volatility timing one-sided strategy.

• Speaker #0

  Interesting name. So you're just timing the downside, essentially. You only shift down to low volatility if the market gives you a strong signal.

• Speaker #1

  Right. And if the market is doing well, you just stick with those mid-volatility stocks.

• Speaker #0

  And how did that perform?

• Speaker #1

  It actually showed some improvement. The volatility actually decreased a little bit, meaning a smoother ride. And the Sharpe ratio and the cumulative wealth, they both went up.

• Speaker #0

  So just timing that downside protection already seems to be adding some value. But the real question is, what about timing both the upside and the downside? Did they test that?

• Speaker #1

  Yes, they did. They called it the volatility timing two-sided strategy.

• Speaker #0

  Okay, that makes sense. So you're just starting in the middle, and then you're shifting in both directions based on the signal.

• Speaker #1

  Exactly. You move up to high volatility when the slope is positive, and down to low volatility when it's negative.

• Speaker #0

  So you're playing both offense and defense. That's got to be where the magic happens, right?

• Speaker #1

  It is. This two-sided strategy, it was the clear winner. Compared to just holding low volatility stocks, it had a much higher Sharpe ratio. And the cumulative wealth was way better.

• Speaker #0

  Wow, that's impressive. So timing both the upside and the downside really seems to unlock the potential of this whole concept. It's like you're playing chess with the market. anticipating the moves, positioning yourself for success.

• Speaker #1

  That's a great way to put it. It's about being agile, not just sitting back and hoping for the best.

• Speaker #0

  I can see your wheel spinning thinking about how to put this into practice.

• Speaker #1

  Hold on, though. We have to look at how those different strategies performed, and then we need to understand why this works so well.

• Speaker #0

  Okay, so that basic version, switching between low and high, yeah, it did better than just holding low volatility stocks. But it was definitely a bumpier ride. Yeah,

• Speaker #1

  that makes sense. What about the Sharpe ratio, though? Did the added risk at least give us better risk-adjusted returns?

• Speaker #0

  Not really. It was actually a little lower than just sticking with low volatility. So you might get more upside, but you're also taking on more risk that maybe isn't worth it.

• Speaker #1

  Okay. So always starting with low volatility, maybe not the best move. How about that volatility timing one-sided thing? Starting with mid-volatility and only going down to low volatility when things get rough.

• Speaker #0

  Okay. So that's where things get a little more interesting. That little tweak. That actually helped. Volatility went down a bit, so smoother ride, and both the Sharpe ratio and the cumulative wealth, those went up. Interesting. So just timing the downside, like the protection part, that seems to already be doing something good. But the real question is, timing both the upside and the downside, like the two-sided thing, that's where the real outperformance is, right? Yeah,

• Speaker #1

  you got it. That's where it really shines. So compared to just holding low volatility stocks, that two-sided strategy got a way higher sharp ratio, jumping from 0.48 to 0.65.

• Speaker #0

  Whoa, that's a big jump. What about the long term, the cumulative wealth? What kind of difference are we seeing?

• Speaker #1

  Oh, it's even better. Imagine the low volatility portfolio gives you, let's say, X amount of return. This two-sided strategy gave you over 11 times that.

• Speaker #0

  All right, now I'm listening. So timing both the up and the down, that really seems to be the key. But why? Why does this work so well? What's going on here?

• Speaker #1

  It seems to be about how the different volatility groups behave, specifically how their prices move together, the correlation, you know.

• Speaker #0

  Correlation, yeah, I hear that word a lot. Can you break that down a bit?

• Speaker #1

  Think of it like a dance floor. If two stocks are highly correlated, they move in sync like a perfectly choreographed waltz, you know. One dips, the other dips. One twirls, the other twirls. But if they're not correlated, they're just freestyling, doing their own thing.

• Speaker #0

  Okay, so I don't want my portfolio to just be a bunch of stocks doing the Macarena. I need some variety.

• Speaker #1

  Exactly. And what they found is those high volatility stocks, they tend to be highly correlated. Like that synchronized dance team, market's good. They all rise together. Your gains get amplified.

• Speaker #0

  Got it. Riding that momentum wave.

• Speaker #1

  Yeah.

• Speaker #0

  But when the music stops.

• Speaker #1

  And then it gets messy. They're so linked that when one falls, the others tend to follow. Domino effect. And that's where the low volatility stocks come in. They're not as correlated, more like solo dancers. They can weather the storm better.

• Speaker #0

  So it's not just about chasing returns. It's about managing risk in a smarter way.

• Speaker #1

  Yeah. Market's looking good. You use that correlation to your advantage. Things get shaky. You switch to those uncorrelated low volatility stocks. It's like a safety net.

• Speaker #0

  Nice. Built-in airbag for your portfolio.

• Speaker #1

  Right. And that two-sided strategy, that's what lets you do that. It's like you're switching between a high growth portfolio when things are good. and a safer, more diversified portfolio when things are bad. Best of both worlds.

• Speaker #0

  Clever. But I'm thinking practically now. Buying and selling all these stocks each month, aren't those transaction costs going to eat into those nice returns?

• Speaker #1

  Yeah, that's a good point. The paper does mention transaction costs are something to think about. They could impact how well this works in real life.

• Speaker #0

  Uh-huh. And slippage too, right? Yeah. Not always getting the price you want when you're buying and selling. Yeah. Especially if you're dealing with stocks that are less liquid.

• Speaker #1

  You're right on the money. Slippage, that's definitely something to think about, especially with a strategy that involves like rebalancing often. It's like trying to catch a moving train. Might not always board at the exact moment you planned.

• Speaker #0

  Okay. So these bad test results look great, but we got to be realistic about those real world things. Transaction costs, slippage, those can make a difference.

• Speaker #1

  For sure. Back tests are a good starting point, but they're not the whole story.

• Speaker #0

  All right. Now thinking bigger picture. This was tested on U.S. stocks, 1963 to 2016. What about other markets? Does this, like, timing volatility thing, does it work globally?

• Speaker #1

  Great question. And the paper itself says that's something to look into more. Their findings are just for the U.S. market.

• Speaker #0

  Okay, so it might work differently elsewhere. And different time periods too, right? Markets change, what worked in the past might not work now.

• Speaker #1

  Exactly. It'd be interesting to see how it does in more recent markets, especially with all the volatility we've seen lately.

• Speaker #0

  Yeah. And different economic cycles too, right? Does it do better during growth periods or during downturns or does it work in all kinds of environments?

• Speaker #1

  Yeah, all good questions, worth looking into more. We don't have all the answers yet, but this research definitely gives us some interesting things to think about.

• Speaker #0

  Yeah, it does. It's like a reminder to keep looking for new ways to invest. You know, don't just assume the old ways are always the best.

• Speaker #1

  Right. Got to keep learning. Keep testing things out. See what works. Yeah,

• Speaker #0

  I like that. Now, before we wrap this up, let's talk about that dynamic diversification thing again. Can you explain that a bit more for everyone?

• Speaker #1

  Most people think diversification is just like spreading your money around.

• Speaker #0

  Yeah, the classic don't put all your eggs in one basket.

• Speaker #1

  But this strategy, it says maybe diversification shouldn't be so like static. Oh, interesting. Like a chameleon, you know, blending in. That's what your portfolio should do. Adapt to the market.

• Speaker #0

  Okay, so instead of just keeping the same mix of assets all the time, you're changing it based on what the market's doing.

• Speaker #1

  Exactly. When things are good, you go all in. When things are bad, you spread out, you know, for protection.

• Speaker #0

  Like a portfolio with like a built-in defense system.

• Speaker #1

  Yeah. You're recognizing that different markets need different portfolios. Market's hot, you concentrate, ride that wave. Things go south, diversify, find safety.

• Speaker #0

  That makes a lot of sense.

• Speaker #1

  And it can help you use your money better. Get those good returns when times are good. Avoid losses when times are bad.

• Speaker #0

  This has been a really great deep dive. We covered a lot from low volatility to timing it to how we build our portfolios.

• Speaker #1

  Yeah, it's been fun seeing how this strategy might actually help us invest better.

• Speaker #0

  Before we go, what's one thing our listeners can take away from this? Something to help them with their own investing.

• Speaker #1

  Don't be scared to try new things. Just because something worked before doesn't mean it's always the best way. Keep learning. Keep looking for ways to improve. You know, get that edge.

• Speaker #0

  I love that. And remember, everyone, investing is a long game. It's a marathon. Patience, being disciplined, and being ready to adapt. That's what matters.

• Speaker #1

  Shouldn't agree more.

• Speaker #0

  Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at https.paperswithbacktests.com. Happy trading!