Beyond Volatility Scaling: Does “Good” and “Bad” Volatility Matter?

Testing whether separating upside and downside volatility can improve risk-adjusted returns across major asset classes

Traditional volatility scaling, reducing exposure when realized volatility is high and increasing it when volatility is low, has been shown to improve risk-adjusted returns for some assets and strategies. The intuition is straightforward: Risk is generally more predictable than returns, so adjusting exposure as risk changes can improve portfolio efficiency without requiring a directional market forecast.

The evidence appears particularly strong for market and momentum portfolios. For example, Schwarz (2025) studies nine factors across 45 international equity markets and finds that, after realistic transaction costs, the clearest benefits remain for market and momentum portfolios.

Harvey et al. (2018), using more than 60 assets with data extending back to 1926, find that Sharpe-ratio improvements are concentrated in equities and credit. For bonds, currencies, and commodities, volatility scaling does little for Sharpe ratios, although it can still reduce tail risk.

In short, volatility scaling appears most useful for equity-like risk assets and much less reliable elsewhere. That raises a natural question: What if we distinguish between upside and downside volatility rather than treating all volatility equally?

In this post, I discuss recent research on this idea and test it across asset classes.