Low volatility anomaly

If you compare the returns from a basket of the lowest beta stocks in the Russell 1000 to the returns from a basket of highest beta stocks, you'd expect to see lower returns from the basket of lower beta stocks based on CAPM. But, empirically the lower volatility portfolios actually have higher average returns, meaning there are cases where lower risk can lead to higher returns. So, where is alpha being generated? And will this anomaly continue to exist?

Some possible explanations:

  • There's a general preference for lottery-like returns.
  • People are trading on non-fundamental demand.
  • It's expensive to short high volatility stocks because of restrictions on using margin.
  • Frequent rebalancing leads to increased tracking error.

As a result of these behaviors, people tend to over index on high beta stocks instead of levering low beta portfolios when seeking higher returns.