How Effective Is the Low-Volatility Anomaly in Trading? (Podcast)
The low-volatility stock anomaly earned its name from its apparent contradiction of the capital asset pricing model (CAPM). In most markets, portfolios of low-volatility stocks actually produce higher risk-adjusted returns than portfolios of high-volatility stocks.
In the January/February 2014 issue of the Financial Analysts Journal, Xi Li, Rodney N. Sullivan, CFA, and Luis Garcia-Feijóo, CFA, CIPM, explored the low-volatility anomaly in the article “The Limits to Arbitrage and the Low-Volatility Anomaly.”
We got the chance to talk with Sullivan about the article.
Recent research has shown that the existence and trading efficacy of the low-volatility anomaly are more limited than widely believed. “Given the combination of these anomalous findings by researchers and the rapid growth in assets under management, it occurred to us that these two issues beg for a deeper understanding of the so-called low-risk anomaly and the extent to which investors can, in reality and in practice, take advantage of the relationship between risk and returns,” Sullivan says.
The authors found no anomalous returns for equal-weighted long–short portfolios, and they found that alpha is largely eliminated when omitting low-priced stocks from value-weighted long–short portfolios. “We found that capturing the profitability of this so-called low-risk phenomenon requires frequent rebalancing,” Sullivan says, “and in fact, we found that in order for the long–short portfolios to have meaningful alpha over time, portfolios have to be rebalanced monthly.”
“The low-volatility anomaly does exist,” he asserts. “We’re not contesting those results, but what we do find is that the efficacy of exploiting this well-known effect is a bit more limited than widely believed.”
To hear Sullivan further discuss his findings, listen to the full interview (above) or download the MP3.
CFA Institute members can access the full article on the CFA Publications website.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
This is a very useful article and follow-up. Anomalies start as a curiosity that academics want to explore further, but investors can’t necessarily use them.
One thing to watch out for is how long the anomalous outperformance persists. Did the academic find it (only) in returns only the next month? The next year? Maybe just the next few hours? All of those are interesting to academics, but an investor can’t make use of any short-term anomaly without incurring pretty significant trading costs, especially if the outperformance reverses after that short initial period. And that seems to be the story with the low-volatility anomaly: it shows up only briefly, which means it’s of interest only to academics and those active traders who end up blowing all of their (gross) returns on fees and expenses.