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Why the Low Volatility Anomaly Will Persist

Last Updated on 10 February, 2024 by Rejaul Karim

Eric G. Falkenstein’s exploration into “Why the Low Volatility Anomaly Will Persist” challenges conventional explanations across 31 pages. Diving into the complexities of market anomalies, Falkenstein questions the common narrative attributing the anomaly to biases or frictions leading investors to overvalue high volatility assets.

Presenting non-standard assumptions, from hybrid relative utility to delusional subsets of investors and residual systematic risk, the paper navigates uncharted territories in the financial landscape.

Falkenstein’s blend of heuristic exploration and data-backed analysis sheds light on why the low volatility anomaly defies traditional explanations, persisting as an enigma in the dynamic world of asset pricing.

Abstract Of Paper

Common explanations of the low volatility anomaly involve biases or frictions that cause investors to overpay for high volatility assets, giving them a negative alpha within the CAPM model, yet currently all such mechanisms are either heuristic or partial equilibrium. This paper shows that leverage constraints of Frazzini and Pedersen (2014) alone cannot explain this result if there also exist rational investors. If 3 non-standard assumptions are added — hybrid relative utility, delusional subset of investors, residual systematic risk across beta — then we can capture several facts existing models cannot simultaneously capture: a positive return to the market, positive holdings by rational investors to negative CAPM-alpha stocks, and a negative Security Market Line. New data relevant to these assumptions are presented.

Original paper – Download PDF

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Author

Eric G. Falkenstein
Pine River Capital Management

Conclusion

Inescapably, the low volatility anomaly appears poised to endure, defying conventional explanations. Eric G. Falkenstein’s meticulous exploration challenges prevailing narratives, revealing the persistence of this anomaly in financial markets. Traditional accounts, rooted in biases or frictions, fall short of comprehensive understanding.

Falkenstein unveils that leverage constraints alone cannot account for this phenomenon in the presence of rational investors. By introducing nuanced assumptions, including hybrid relative utility and a delusional subset of investors, the study captures intricate market dynamics.

The anomaly’s resilience is underscored by observed positive market returns, rational investors holding negative CAPM-alpha stocks, and a distinctive negative Security Market Line. This research signals the complexity of low volatility’s longevity, urging a continued unraveling of its multifaceted underpinnings.

Related Reading:

Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly

The Low-Volatility Anomaly: Market Evidence on Systematic Risk versus Mispricing

FAQ

Q1: What is the primary focus of Eric G. Falkenstein’s research on the low volatility anomaly?

A1: The research by Eric G. Falkenstein challenges conventional explanations for the low volatility anomaly. Instead of attributing it to biases or frictions leading investors to overvalue high volatility assets, Falkenstein explores non-standard assumptions, including hybrid relative utility, a delusional subset of investors, and residual systematic risk across beta.

Q2: How does Falkenstein challenge existing explanations for the low volatility anomaly?

A2: Falkenstein challenges traditional explanations, particularly those rooted in biases or frictions, by introducing non-standard assumptions. He argues that leverage constraints alone, as proposed by some existing models, cannot explain the anomaly in the presence of rational investors. The paper explores hybrid relative utility, delusional subsets of investors, and residual systematic risk to provide a more comprehensive understanding.

Q3: What does the research suggest about the persistence of the low volatility anomaly, and what factors contribute to its endurance?

A3: The research suggests that the low volatility anomaly is likely to persist, and its endurance is attributed to the interplay of non-standard factors. Falkenstein introduces assumptions like hybrid relative utility and a delusional subset of investors to capture complex market dynamics. The study underscores the anomaly’s resilience by considering observed positive market returns, rational investors holding negative CAPM-alpha stocks, and a distinctive negative Security Market Line.

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