Backtested a Volatility Strategy From an Academic Paper, Beat Market by 4x

I recently backtested a “volatility managed strategy” from Alan Moreira and Tyler Muir’s 2017 paper “Volatility Managed Portfolios”. My results show that following their methodology for a little over the past decade would have significantly outperformed the market.

Specifically, starting from 2010, the volatility managed strategy saw a total return that was more than four times greater than the buy and hold strategy. Put in other words, $100 invested in said strategy in 2010 would have turned into more than $1700 today, while $100 invested in a buy and hold strategy would have turned into just $480. Even better, this strategy appears to be relatively accessible to a retail trader through the ETFs: SPY, UPRO, & VGSH.

Backtest results

TLDR

The general idea behind the strategy is to weave in and out of SPY (ETF for the S&P 500) based on market volatility. If the market is volatile, we stay in safe US government bonds (VGSH, ETF for short term US treasuries), and if the market is calm, we buy into SPY with leverage.

The reason this works is that the US stock market generally goes up, especially in low volatility periods, and low volatility also significantly reduces the cost of leverage.

We can measure market volatility by calculating the recent variance of the price of SPY.

Here’s a high level summary of the process:

• If the variance of SPY is below a certain threshold (low volatility):

• Invest in SPY with leverage

• If the variance of SPY is above a certain threshold (high volatility):

• Invest in safe US government bonds

Diving Just a Bit Deeper

In their paper, Moreira & Muir suggest that over the past ~100 years, investors would have been able to achieve positive alpha in their portfolio by regularly adjusting their equity exposure as realized volatility fluctuates. In low volatility periods, you want to be invested in the S&P 500 and with leverage (low volatility means cheaper and safer leverage) and in high volatility periods, shelter in safe US treasuries.

Our backtest showed that most of the time, using this strategy, you’d be leveraged in S&P 500. This is because volatility in the past decade has been extraordinarily low.

This paper was written in 2017 yet the strategy they put forth worked incredibly well during COVID. The strategy shifted exposure almost entirely into US treasuries at the beginning of the pandemic and remained there until around June before returning to its normal leveraged position which allowed it to take advantage of the bull run that occurred in the back half of that year.

To put this in practice and make it easily accessible for a retail investor, we chose to use the 3 ETFs: SPY, UPRO, and VGSH. For cheap and simple leverage with S&P 500, who use a mix of SPY and UPRO (3x leveraged S&P 500 ETF). However, this also means that you can leverage up to only 3x but this should be enough.

This practical strategy tracked the ideal strategy in the paper pretty closely and only slightly underperformed.

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