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Volatility-Managed Factor Overlay
scale total factor exposure inversely to each factor's own realized variance
Scaling a factor by the inverse of its recent realized variance raises risk-adjusted returns because volatility spikes are not matched by proportional jumps in expected return; the foundational study reports roughly a 25% Sharpe increase for the market and gains across value, momentum, profitability and investment factors by de-risking exactly when volatility is high. Applied as a time-series gross-exposure overlay across a factor suite, this is distinct from single-asset vol targeting (multi-factor, timing overlay) and from cross-sectional inverse-vol risk parity (which stays fully invested).
Universe
Factor ETF suite MTUM / VLUE / QUAL / USMV / SIZE, with idle capital in BIL/SHY when scaled exposure < 1.
How it works
Monthly, for each factor ETF scale weight by (target vol ÷ its trailing 21-day realized vol), cap leverage at 1.0 and park the unused fraction in BIL; combine equal-weighted, rebalance monthly.
Expected performance
Research-derived Sharpe estimate: 0.4–0.8.
Backtest this idea with SignalChain
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/signalchain Volatility-managed overlay scaling MTUM/VLUE/QUAL/USMV/SIZE each by inverse 21-day realized variance to constant target vol, unused capital in BIL, monthly
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Research & sources
- papers.ssrn.com — papers.ssrn.com
- nber.org — nber.org
- lbsresearch.london.edu — lbsresearch.london.edu
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