A Behavioral Finance Explanation for the Success of Low Volatility Portfolios
22 Pages Posted: 26 Jun 2013
Date Written: January 2010
Arguably the most remarkable anomaly in finance is the violation of the risk‐return tradeoff within the stock market: Over the past 40 years, high volatility and high beta stocks in U.S. markets have substantially underperformed low volatility and low beta stocks. We propose an explanation that combines the average investor's preference for risk and the typical institutional investor's mandate to maximize the ratio of excess returns to tracking error relative to a fixed benchmark (the information ratio) rather than the Sharpe ratio. Models of delegated asset management show that such mandates discourage arbitrage activity in both high alpha, low beta stocks and low alpha, high beta stocks. This explanation is consistent with several aspects of the low volatility anomaly including why it has only strengthened even as institutional investors have become more numerous.
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