Incorporating Smart Beta into Portfolios: A Case Study with the Volatility Risk Premium

Abstract

As the latest addition to the basic equity smart beta factors, the volatility risk premium (VRP) has become an attractive potential source of additional returns for investors. The VRP is generally defined as the difference between the implied volatility of options and the subsequently realized volatility. However, few VRP-based investment products are available that both deliver consistent returns and are low cost. The focus of this article is how investors can incorporate the VRP into typical portfolios, exemplified by a balanced 60/40 portfolio and an equal-weight, multi-asset diversified portfolio. The article explores two different methods, the dedicated VRP construct (long only) and the overlay VRP construct (long–short) and concludes that both methods can potentially enhance investors’ portfolio returns without significantly altering the portfolio’s risk profile because the VRP is an attractive and traditionally untapped source of returns that has exhibited low correlations with traditional risk premiums. The conclusions drawn in the article may be applicable to the task of incorporating other smart beta factors into portfolios.