Long volatility strategies versus tactical asset allocation


Risk management in portfolio construction is primarily achieved through diversification or rules-based frameworks. The first is simply to combine asset classes that have tended to be poorly correlated, for example bonds and equities over the past decades. The latter involves setting rules on when to exit, for example, if the S&P 500 falls below the 200-day moving average, and then reallocating capital from stocks to bonds.

Diversification has become more difficult as the primary diversifier, ie bonds, has become less attractive given low interest rates, especially in a rising interest rate environment. Additionally, many seemingly uncorrelated strategies like hedge funds or private equity have proven to provide nothing more than hidden equity exposure.

Investors frequently consider hedge funds extreme risk for diversification, but these tend to be too negatively correlated to equities, making them not extremely useful tools in portfolio construction. Long volatility strategies are more suitable as they only have moderately negative correlations, but only a few asset managers offer this strategy and none in a public vehicle like an ETF.

Considering this, a rule-based approach is perhaps superior as it can be easily implemented. In this research note, we will contrast long volatility and tactical asset allocation (TAA) strategies for equities.

Benefits of Diversifying Long Volatility Strategies

Long volatility strategies aim to take advantage of increasing or high volatility in equity markets and use options as well as risky assets in portfolio construction. The gain during a stock market crash will be less than that of an extreme risk hedge fund, but there will also be less consistent losses during bull markets.

We use the CBOE Long Volatility Hedge Fund Index as a benchmark for long volatility strategies. The index is made up of 15 equally weighted hedge funds and has offered monthly returns since 2004.

We observe that long volatility strategies have offered attractive returns during periods of crisis such as the global financial crisis in 2008 and the COVID-19 crisis in 2020, where volatility soared.


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