Author(s): Tony Cooper
Date: August 6, 2010
Abstract: It is difficult to predict stock market returns but relatively easy to predict market volatility. But volatility predictions don’t easily translate into return predictions since the two are largely uncorrelated. We put forward a framework that produces a formula in which returns become a function of volatility and therefore become somewhat more predictable. We show that this strategy produces excess returns giving us the upside of leverage without the downside.
As a side-effect the strategy also smoothes out volatility variation over time, reduces the kurtosis of daily returns, reduces maximum drawdown, and gives us a dynamic timing signal for tilting asset allocations between conservative and aggressive assets. It has been said that diversi cation is the only free lunch in investing. It appears that once you have diversi ed away some risk you can get a further free lunch by smoothing what risk remains.