Uncertainty-Managed Portfolios

Abstract

A managed equity market portfolio that takes less risk when market volatility is high produces large alphas. I document that this surprising feature of the data is driven by momentum, because market volatility has significant and robust predictive power for momentum profits. Furthermore, I find that the time-series volatility-managed portfolio is also not completely distinct from the low-beta anomaly documented in the cross-section. However, in line with asset pricing theory, forward-looking measures of uncertainty based on options implied information can be expected to be strong predictors of equity market returns. Using title and abstract of front-page articles of the Wall Street Journal, Manela and Moreira (2017) construct a ‘VIX-type’, but text-based measure of uncertainty starting in 1890. Uncertainty-timing might increase Sharpe ratios because changes in uncertainty are not necessarily correlated with changes in equity risk and, therefore, not offset by proportional changes in expected returns. I show that lagged news-based uncertainty explains future excess returns on the market portfolio at the short horizon. While policy-and war-related concerns mainly drive these predictability results, stock market-related news has no predictive power. In particular, policy-related uncertainty foresees the attractiveness of the mean-variance trade-off. A managed equity portfolio that takes more risk when news-based uncertainty is high generates an annualized equity-risk-adjusted alpha of 5.33% with an appraisal ratio of 0.46. Managing news-based uncertainty is in contrast to conventional investment wisdom, because the strategy takes relatively less risk in recessions, which rules out typical risk-based explanations.