Reducing Transaction Costs in Volatility-Managed Portfolios

Volatility targeting is a risk and portfolio management technique that adjusts exposure based on changes in asset volatility. We have discussed volatility targeting methods in previous posts, for example, Applying Volatility Management Across Industries. While effective, this technique requires frequent rebalancing. As with any approach involving high turnover, such as delta hedging, transaction costs can significantly erode performance.

Reference [1] investigates the volatility targeting technique under the constraint of transaction costs. Specifically, it introduces a rebalancing boundary, which triggers adjustments only when certain conditions are met. In other words, the target volatility portfolio E, with the rebalancing boundary, modifies its asset allocation only when the ratio of target volatility to asset volatility deviates from the desired ratio by at least a predefined threshold.

The authors pointed out,

To reduce the transaction costs that a target volatility strategy may encounter over an investment horizon, we incorporate a novel rebalancing boundary setup into the volatility target asset allocation mechanism. We identify the optimal rebalancing boundary level that maximizes a portfolio return measure while controlling the portfolio’s risk measure within a constrained optimization setting, focusing on the Omega ratio and mean volatility deviation as the portfolio return and risk measures, respectively. We evaluate the performance of the target volatility portfolio with the optimal rebalancing boundary (“Optimized Portfolio E”) and contrast it with a traditional target volatility portfolio without such rebalancing boundaries (“Portfolio S”) by conducting comparative analysis under different market scenarios. We find that the optimized Portfolio E contains significantly lower transaction costs while generating higher returns than the benchmark Portfolio S. Moreover, the optimized Portfolio E realizes lower portfolio downside risk, as indicated by a higher level of Value-at-Risk (VAR) than Portfolio S. This suggests that our proposed enhancement to the target volatility strategy by adding the rebalancing boundary level does not compromise portfolio risk control.

In short, using a rebalancing boundary reduces transaction costs and improves the portfolio’s risk-adjusted returns.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Zefeng Bai, Dessislava Pachamanova, Victoria Steblovskaya, Kai Wallbaum, Target volatility strategies: optimal rebalancing boundary for transaction cost minimization, Financial Markets and Portfolio Management, 2025

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