Why Do Firms with High Idiosyncratic Volatility and High Trading Volume Volatility Have Low Returns?

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Ang, Hodrick, Xing and Zhang (2006) document a negative relation between returns and idiosyncratic volatility (hereafter the AHXZ result). We show their result is significant and robust to various measures of idiosyncratic volatility and various return horizons after deleting penny stocks and controlling for January. Moreover, their result is not attributable to small firms. We examine whether the market misprices high idiosyncratic volatility stocks in a manner consistent with the effects of limits of arbitrage and information uncertainty. The results are supportive of this hypothesis. The AHXZ result exists only among stocks with low analyst coverage, and is strongest among low-coverage stocks with high returns over the prior three years. Earnings announcement returns are negative and significant for high idiosyncratic volatility stocks with low analyst coverage, but not those outside the low-coverage group. Outside of low-coverage stocks, the relation between returns and idiosyncratic volatility is insignificant or positive. Distinct patterns in earnings indicate that the AHXZ result arises because the market overestimates the persistence of earnings growth for low-coverage stocks with high idiosyncratic return volatility. We document a similar collection of results for stocks sorted on the volatility of share turnover, suggesting that the negative relation between returns and turnover volatility documented by Chordia, Subrahmanyam and Anshuman (2001) also reflects mispricing consistent with information uncertainty and limits of arbitrage.