Strategy 3: Low Volatility Anomaly

This strategy is based on the empirical observation that future returns of previously low-return-volatility portfolios outperform those of previously high-return-volatility  portfolios, which goes counter to the “na’ıve” expectation that higher risk assets should yield proportionately higher returns.   Thus, if σi is defined as the historical volatility (computed over a time series of historical returns,), the trader can, e.g. construct a dollar-neutral portfolio by buying stocks in the bottom decile by σi (low-volatility stocks), and shorting stocks in the top decile (high-volatility stocks). The length of the sample used for computing the historical volatility can, e.g., be 6 months (126 trading days) to a year (252 trading days), with a similar duration for the holding period (with no “skip period” required).

Let us look at a summary of some papers supporting the above:

 1. [Ang et al, 2006]:

   This paper by Ang, Hodrick, Xing, and Zhang investigates the relationship between stock returns and idiosyncratic volatility (company-specific volatility) over a long time horizon. The authors find that stocks with lower idiosyncratic volatility tend to have higher risk-adjusted returns, challenging the traditional risk-return trade-off.

 2. [Ang et al, 2009]:

   Building on their earlier work, Ang, Hodrick, Xing, and Zhang's 2009 paper examines whether the low-volatility effect extends to international equity markets. They find that the anomaly is present globally, suggesting that it's not limited to a specific market or region.

 3. [Baker, Bradley and Wurgler, 2011]:

   Baker, Bradley, and Wurgler's study delves into the behavioral explanations for the low-volatility anomaly. They suggest that investor sentiment and behavioral biases can lead to the underpricing of low-volatility stocks. In periods of high investor sentiment, investors tend to overpay for high-risk stocks, which drives down their expected returns.

 4. [Black, 1972]:

   Fischer Black's 1972 paper contributes to the understanding of the relationship between risk and return. He introduces the concept of a risk premium, where assets with higher risk should offer higher expected returns. The low-volatility anomaly challenges this notion by showing that low-risk assets can also yield higher returns.

 5. [Blitz and van Vliet, 2007]:

   Blitz and van Vliet's paper focuses on the practical implementation of the low-volatility strategy. They propose that constructing a portfolio of low-volatility stocks can provide attractive risk-adjusted returns. Their research emphasizes the importance of portfolio construction and rebalancing.

 6. [Clarke, de Silva and Thorley, 2006]:

   This paper by Clarke, de Silva, and Thorley examines the low-volatility effect in the context of different stock market sectors. The authors find that the anomaly is present within sectors as well, indicating that it's not limited to specific industries.