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

Abstract

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 article 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, that is, hedge funds tend to bet not against the low-volatility anomaly, rather than on it. 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.