Why Low-Volatility Stocks Outperform
Market Evidence on Systematic Risk Versus Mispricing
BY Rodney Sullivan, Xi Li | November 23, 2011
(SSRN) In what is sometimes collectively referred to as the “low-volatility” anomaly, researchers have discovered a provocative long-term connection between future stock returns and various measures of prior stock price variability, including total return volatility, idiosyncratic volatility, and beta. More to the point, researchers document that, in both U.S. and international markets, future stock returns of previously low return variability portfolios significantly outperform those of previously high return variability portfolios [see, e.g., Ang, Hodrick, Xing, and Zhang (2006 and 2009), Baker, Bradley, and Wurgler (2010), Clarke, de Dilva, and Thorley (2006), and Blitz and Vliet (2007)]. These empirical findings are particularly intriguing because, of course, economic theory dictates that higher expected risk is compensated with higher expected return. As such, these findings highlight the need to gain a better understanding of the underpinnings of this curious anomaly. To date, however, only a few have offered an explanation for its existence; more specifically, whether it is driven by some systematic risks or investor mispricing.
Our research effort seeks to gain fruitful insight into the low-volatility anomaly. We do so by examining whether this anomaly can be attributed to market mispricing or to compensation for higher systematic (undiversifiable) risk.mIn making this differentiation, we address a fundamental issue for investors. Should the anomaly be related to systematic risk, then the excess returns can be viewed as arising from some, as of yet unknown, common risk factor(s). Alternatively, it may be driven by a mispricing, as perhaps associated with an imperfection such as investor irrationality connected with volatility. The importance of these issues bolsters our formal investigation into answering the underlying question of whether the documented low-volatility effects are associated with some market mispricing or (as of yet unidentified) pervasive systematic risks. Though, in this paper we focus our discussion on the well-known idiosyncratic risk factor, we not surprisingly find similar results for total volatility. Read the full paper.