The Low-Risk Anomaly: How Much Is a Good Risk Estimate Worth?

Abstract

Many academics and practitioners rely on standard, relatively basic methods to estimate and manage portfolio risk. This can affect an investment manager’s ability to accurately target lower volatility stocks designed to exploit the well-documented low-risk anomaly. This article finds a hybrid risk estimate that mixes short-, medium-, and long-term variances, leads to superior ex post information ratios and alphas by properly aligning securities in the correct order (low risk to high risk). This risk estimate may be worth between $420 million and $1.9 billion annually, calculated from the overall size ($75 billion) of the market. The significance of this estimate survives transaction costs, various time periods, and risk factor exposures. TOPICS:Factors, risk premia, factor-based models, passive strategies, portfolio construction, risk management Key Findings • We propose an alternative way to built portfolios designed to exploit the low-risk anomaly. • The alpha due to this alternative method alone is anywhere from $420 million and $1.9 billion annually, given the current size ($75 billion) of this market. • The significance of this approach survives transaction costs, various time periods, and risk factor exposures.