Managing the Risk of the Low-Risk Anomaly

Abstract

Betting-against-risk (BAR) anomaly portfolios formed on past beta and idiosyncratic/total volatility produce large CAPM alphas. But these return spreads are well explained by the Fama--French six-factor model (FF6). Operating profitability, investment, and momentum factors subsume the low-risk anomaly. However, risk-managed versions of the same low-risk anomalies are substantially more puzzling. Specifically, risk management increases the Sharpe ratio in 29 out of 30 cases examined and significantly increases the risk-adjusted returns for all BAR portfolios. Splitting the sample by lagged volatility, it follows that the risk factors in FF6 explain low-risk anomalies only after months of high volatility---exactly those periods when the anomaly is weak. Indeed, all BAR long-short portfolios earn significant abnormal profits following low-volatility months. By splitting the total variance of each low-risk factor, into systematic and idiosyncratic components, the later drives the gains of timing risk. Our results suggest that risk management resurrects the low-risk anomaly.

Keywords: Betting-against-beta, BAB, time-varying risk, momentum, realized volatility, risk factors, scaled factors, market anomalies

JEL Classification: G11, G12, G17