The VIX index is one of the most widely followed market volatility gauges. Investors trying to capture volatility have had two ETNs at their disposal the past 15 months: iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). Anyone who has followed these ETNs is keenly aware that the products themselves are volatile securities.

There are many approaches to managing risk. One of the more popular methods is “targeted relative volatility” where a portfolio tries to match the volatility of a benchmark. Unfortunately, because volatility is not constant the volatility of a portfolio using this approach will also not be constant.

I have a different view. I try to reduce relative volatility when the market is experiencing increased volatility and try to increase relative portfolio volatility during periods of decreased market volatility. The net result is that portfolio volatility is much more consistent relative to the market – the volatility of volatility is lower.

A few weeks ago, I had the privilege of seeing a paper presented, Alpha Generation and Risk Smoothing using Volatility of Volatility. The author and presenter was Tony Cooper of Double-Digit Numerics, Auckland, New Zealand. Tony looks at volatility of volatility, which he refers to as “vovo”, from a new and promising perspective and proposes methods for mathematically managing volatility.

Tony says it is difficult to predict stock market returns but relatively easy to predict volatility. His framework produces a formula in which returns become a function of volatility and therefore more predictable. He goes on to show that the strategy produces excess returns as the upside of leverage without the downside.

His approach is to estimate volatility using an EGARCH model and employ leveraged funds to adjust portfolio leverage. There is an excellent discussion on leveraged funds and volatility drag. He asserts that many of the “negative” effects of leveraged funds are not induced by the leverage. Instead, they are a function of volatility and are present even in non-leveraged funds. The leverage just magnifies the volatility.

The paper has excellent graphs showing the effects of leverage and identifying the historically optimum leverage for selected markets. Tony observes that most equity markets benefit from some leverage but that none will reward a leverage of 4.

The paper illustrates how to implement a Constant Volatility Strategy and an Optimal Volatility Strategy. As part of the backtesting and benchmarking process, the results of additional strategies are described. For those of us who do not relish leveraged funds, the vovo approach also works when restricted to a maximum leverage of one.

As mentioned earlier, I got to see a presentation of Tony’s paper. The occasion was the annual conference of the National Association of Active Investment Managers (NAAIM), of which I am a board member, earlier this month in Orlando. Tony won this year’s Wagner Award for Advancements in Active Investment Management. I encourage anyone seeking additional information to download the complete paper at the NAAIM site.

Jeff Benjamin of Investment News was at the conference. As part of his interview with Tony Cooper, Jeff asked him what he intended to do with the prize money. Tony’s response was that he “would like to invest it in a targeted-volatility ETF as soon as one is created.” I too would be interested in such a product.

Since Tony’s vovo strategy fits very well with my desire to achieve more consistent volatility within the portfolios I manage, I will be studying the paper in more depth in the weeks and months to come.

Disclosure covering writer, editor, publisher, and affiliates: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.