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Skeptical On The Low-Vol ‘Factor’

The superior performance of low-volatility stocks was initially documented in the literature back during the 1970s, by Fischer Black, among others. That’s even before the size and value premiums were officially “discovered.”

And since its existence became known, two main explanations for the low-volatility phenomenon have arisen. They are that:

  • Many investors are either constrained against the use of leverage or have an aversion to it. Such investors tend to seek higher returns by investing in high-beta (or high-volatility) stocks, despite the fact that the evidence shows they have delivered poor risk-adjusted returns. Limits to arbitrage and aversion to shorting, as well as the high costs associated with shorting such stocks, prevents arbitrageurs from correcting the pricing mistake. Because these investors seem to prefer unleveraged risky assets to leveraged safe assets, they hold portfolios of high-beta assets with lower alphas and Sharpe ratios than portfolios of low-beta assets.
  • Some investors have a “taste,” or preference, for lotterylike investments. This leads such investors to “irrationally” invest in high-volatility stocks (which have lotterylike distributions) despite their poor returns. In other words, they pay a premium to gamble.

Read the rest of the article on ETF.com.

 

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