In the wake of the first quarter correction, we ran some simulations to see if reducing risk in higher volatility markets can improve the overall efficiency of our strategy. We used compound annual return divided by the standard deviation of returns as our efficiency metric, a sort of poor man’s Sharpe ratio.

In the first simulation, we set stock market exposure by the book until the VIX reached a certain level. Once that “breakpoint” was hit, we gradually reduced exposure as the VIX rose. Here is the rule we used:

1) If VIX <= Breakpoint VIX Level                            Unadjusted Exposure

2) If VIX > Breakpoint VIX Level                             (Breakpoint/Previous Day VIX) x Unadjusted Exposure

Here are the results of the simulation that ran from January 2003 to mid-February 2018:

Table 1 Breakpoint Results 01/02/2003–02/14/2018

The simulation showed that the Breakpoint strategy did not make the strategy more efficient. Indeed, it held constant at about 1.32, plus or minus 0.01 efficiency units.

In the second simulation we targeted a constant volatility. When the VIX was higher than the target volatility, we cut back, and just the opposite when the VIX was below the target volatility. Here is the rule we used:

Exposure = (Constant Volatility Target / Previous Day VIX) x Unadjusted Exposure

Here are the results from Simulation Two:

Table 2 Constant Volatility Results 01/02/2003–02/14/2018

The simulation results showed that setting constant volatility target does not improve efficiency.

In the third simulation we cut back exposure when the VIX rose above its 5- and 10-day moving averages. The idea here is cut back when the VIX rises above recent levels.

Here is the rule we used:

Exposure = (Moving Average VIX / VIX)  x Unadjusted Exposure

Here are the results from the third simulation:

Table 3 10- and 5-Day Moving Average Results 01/02/2003 – 02/14/2018

The moving average idea did not increase efficiency, either.

We think we know why these ideas did not increase the efficiency of the strategy. Our signals are, on average, just as good in both high and low volatility markets. So we are not able to improve strategy efficiency by cutting back in higher volatility markets. We can target a certain volatility level, but returns drop in line with a reduction in the volatility target. Our current volatility target is 80% of the long term volatility of the S&P 500, about 13%.

©2018 Hull Tactical Asset Allocation, LLC (“HTAA”) is a Registered Investment Adviser.

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