Volatility Creates Additional Returns: Flat Exposure is A Better Investment Approach than Buy-and-Hold

Abstract

The expected returns have to be converged to the single rate in the same equity market through arbitrage as the return difference provides an arbitrage opportunity, which recurs to narrow any differentials. The beta is eventually unnecessary as a composition of the equity cost computation through this mechanism. However, the volatility is still a risk to the equity investment in terms of the convention to cut a loss when the stock price plunges out of the predestined range. The combination of those notions implies that the lower risk portfolio yields a better return with the same expected return, such as the value-tilted strategy. There is a way to enhance the return with the volatility, which is named as “Flat Exposure”, to fix the portfolio exposure to the flat rate, rebalancing it at the end of each term. I set up 50% equity and 50% cash for the backtest, where the equity portion might expand to 54% or shrink to 45%, which is rebalanced back to the 50% each at the end of the term. The test confirms that the flat exposure portfolio yields more return than Buy-and-hold. This outcome is pivotal as both strategies are based on exactly the same asset, indicating that there is a structural way to enhance the portfolio performance with a utilization of the beta. Actually, the more volatility, the more returns the flat exposure creates at the same security and return, which is partially against Sharpe ratio. We need always to reexamine our conventional wisdom to create a better future.