Tail Risk Targeting: Target VaR and CVaR Strategies

Abstract

We present dynamic trading strategies that target a predefined level of risk measured by volatility, Value-at-Risk (VaR) or Conditional-Value-at-Risk (CVaR). Recent studies have shown that volatility targeting increases the risk-adjusted performance and heightens utility gains for mean-variance investors. We find that downside risk targeting outperforms volatility targeting in terms of higher Sharpe Ratios, better drawdown protection and higher utility gains for mean-variance, CRRA and loss-averse investors. In particular, a loss-averse investor is not willing to pay a positive fee to switch from a static portfolio to a volatility managed strategy, whereas the same investor would pay a fee of 18% per year to have access to the downside risk managed strategy. The performance of risk targeting can further be enhanced by switching between volatility and CVaR targeting based on estimates of whether the market will be in a bull or bear regime. This strategy successfully reduces the drawdowns during the global financial crisis and the recent corona crisis.