Volatility Managed Multi-factor Portfolios

This paper shows that portfolio performance can be improved significantly when jointly using volatilities of past factor returns and option-implied market volatilities to determine factor exposures. Improvements are much larger in risk regimes characterized by option-implied right-skewed and/or high vola market returns. When model parameters are estimated separately for different regimes, risk-adjusted portfolio returns improve even further. The results are not driven by a specific set of factors but also achieved when principal components of a large universe of factors are used as factors. The findings are robust to transaction costs and to out-of-sample estimation.