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Are Hedge Funds on the Other Side of the Low-Volatility Trade?

Last Updated on 10 February, 2024 by Rejaul Karim

Navigating the intricate landscape of financial anomalies, David Blitz delves into the realm of low volatility in “Are Hedge Funds on the Other Side of the Low-Volatility Trade?” Commonly linked to arbitrage limits, this anomaly contradicts expectations when viewed through the lens of hedge funds.

While often considered the savvy operators unrestricted by common trading constraints, hedge funds intriguingly appear to wager against the low-volatility phenomenon. Unveiling this paradox, Blitz challenges conventional notions and hints that the narrative surrounding low volatility as an ‘overcrowded’ trade might be overstated.

In this financial odyssey, the study not only dissects the low-volatility anomaly but also unearths a fresh explanatory factor influencing hedge fund returns.

Abstract Of Paper

The low-volatility anomaly is often attributed to limits to arbitrage, such as leverage, short-selling and benchmark constraints. One would therefore expect hedge funds, which are typically not hindered by these constraints, to be the smart money that is able to benefit from the anomaly. This paper finds that the return difference between low- and high-volatility stocks is indeed a highly significant explanatory factor for aggregate hedge fund returns, but with the opposite sign, i.e. hedge funds tend to bet not on, but against the low-volatility anomaly. This finding suggests that limits to arbitrage are not the key driver of the low-volatility anomaly and that concerns about low-volatility having become an ‘overcrowded’ trade may be exaggerated. Another contribution of this study is that it identifies a new, highly significant explanatory factor for hedge fund returns.

Original paper – Download PDF

Here you can download the PDF and original paper of Are Hedge Funds on the Other Side of the Low-Volatility Trade?.

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Author

David Blitz
Robeco Quantitative Investments

Conclusion

In summary, the puzzle of the low-volatility anomaly persists as hedge funds, often considered unrestricted by common arbitrage constraints, unexpectedly position themselves against this market phenomenon. While limits to arbitrage, including leverage and short-selling restrictions, are frequently cited as contributors to the anomaly, our findings challenge this narrative.

The significant influence of the return difference between low- and high-volatility stocks on aggregate hedge fund returns, albeit in the opposite direction, implies that hedge funds are not capitalizing on the low-volatility anomaly but rather betting against it.

This revelation challenges prevailing assumptions about the overcrowded nature of the low-volatility trade and underscores the need for a deeper understanding of the forces driving this enduring market anomaly.

Related Reading:

Low Risk Anomaly Everywhere – Evidence from Equity Sectors

The Volatility Effect Revisited

FAQ

1. What common expectation does David Blitz challenge regarding hedge funds and the low-volatility anomaly?

David Blitz challenges the common expectation that hedge funds, being typically unrestricted by common arbitrage constraints such as leverage, short-selling, and benchmark limitations, would be the smart money benefiting from the low-volatility anomaly. Instead, the study finds that hedge funds tend to bet against the low-volatility anomaly, contrary to what would be expected given their perceived flexibility in trading strategies.

2. What does the paper identify as a highly significant explanatory factor for aggregate hedge fund returns, and what is the unexpected finding regarding the direction of this factor?

The paper identifies the return difference between low- and high-volatility stocks as a highly significant explanatory factor for aggregate hedge fund returns. However, the unexpected finding is that hedge funds tend to position themselves against the low-volatility anomaly, taking a stance contrary to the positive return difference between low- and high-volatility stocks.

3. What does the study’s findings suggest about the prevailing narrative regarding the overcrowded nature of the low-volatility trade, and what broader implication does this have for understanding the low-volatility anomaly?

The study’s findings suggest that concerns about the low-volatility trade being overcrowded may be exaggerated. The fact that hedge funds, often considered sophisticated and unrestricted investors, are not positioning themselves to capitalize on the low-volatility anomaly challenges the conventional narrative. This unexpected positioning of hedge funds against the low-volatility anomaly implies that limits to arbitrage, including those usually associated with hedge funds, may not be the key driver of the anomaly. This, in turn, highlights the need for a deeper understanding of the forces influencing and sustaining the low-volatility anomaly in financial markets.

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