The Factor Risk in Low-Risk Anomalies
55 Pages Posted: 13 Nov 2019 Last revised: 11 Nov 2021
Date Written: November 10, 2021
The low variance (LV) strategy always bets against the volatile leg of common factor-portfolios. The risk of the strategy, measured by factor exposures, is thus perfectly predictable based on the status of factor portfolio variances during the formation period. I find that the strategy earns alpha only when traders have to bear major factor risk to arbitrage it away. These results are consistent with models that rationalize anomalies by arbitrageurs reluctance to eliminate mispricing due to factor risk aversion. I use the framework to analyze the sources of risk and return to popular volatility trading strategies and propose a new trading strategy that uses time-series factor data to manage the variance strategy in the cross-section.
Keywords: Risk Return Trade-off, Volatility Effect, Variance Anomaly, Factor Risk
JEL Classification: G11, G12, G17
Suggested Citation: Suggested Citation