The Limits to Arbitrage and the Low-Volatility Anomaly

The authors found that over 1963–2010, the existence and trading efficacy of the low-volatility stock anomaly were more limited than widely believed. For example, they found no anomalous returns for equal-weighted long–short (low-risk minus high-risk) portfolios and that alpha is largely eliminated when omitting low-priced stocks from value-weighted long–short portfolios. Furthermore, performance of long–short portfolios was significantly reduced by high transaction costs, reflecting the finding that the abnormal returns were concentrated among low-liquidity and smaller stocks. Amplifying liquidity needs, the anomalous excess returns quickly reversed, requiring frequent rebalancing. The authors’ findings have meaningful implications for implementing low-risk equity portfolio strategies.We found that over a long study period (1963–2010), the existence and trading efficacy of the well-known low-volatility stock anomaly are more limited than widely believed. For example, we found no anomalous returns to equal-weighted long–short (low-risk minus high-risk) portfolios. In value-weighted portfolios, alpha is largely eliminated when low-priced (less than $5) stocks are excluded. Furthermore, extracting any excess returns to a long–short portfolio is meaningfully hampered by high transaction costs, reflecting the finding that the abnormal returns are concentrated among low-liquidity and smaller stocks. Adding to the challenge, the anomalous excess returns quickly reverse, requiring traders to rebalance frequently in attempting to extract profits, thus amplifying liquidity needs. Our findings have meaningful implications for those attempting to implement low-risk equity portfolio strategies.Editor’s Note: Rodney N. Sullivan, CFA, is editor of the Financial Analysts Journal. He was recused from the referee and acceptance processes and took no part in the scheduling and placement of this article. See the FAJ policies section of cfapubs.org for more information.