Single-Asset Adaptive Leveraged Volatility Control

TL;DR

This paper presents a proportional-control method for constructing a market index with fixed target volatility, improving stability and practicality over traditional open-loop strategies.

Contribution

It introduces a feedback-based approach for volatility targeting that reduces turnover and leverage spikes, enhancing index construction methods.

Findings

The proposed method more reliably maintains target volatility in simulations.

It reduces portfolio turnover compared to open-loop strategies.

The approach is transparent and requires only a few parameters.

Abstract

This paper introduces a methodology for constructing a market index composed of a liquid risky asset and a liquid risk-free asset that achieves a fixed target volatility. Existing volatility-targeting strategies typically scale portfolio exposure inversely with a variance forecast, but such open-loop approaches suffer from high turnover, leverage spikes, and sensitivity to estimation error -- issues that limit practical adoption in index construction. We propose a proportional-control approach for setting the index weights that explicitly corrects tracking error through feedback. The method requires only a few interpretable parameters, making it transparent and practical for index construction. We demonstrate in simulation that this approach is more effective at consistently achieving the target volatility than the open-loop alternative.