Benchmark followers amplify the low volatility effect. In our seminal paper1 on low-volatility investing, published in 2007, we argued that the anomaly might be caused by benchmark-driven investing, as this gives fund managers the incentive to over-invest in high-risk stocks.
For those who were not convinced yet, a new paper2 by Christoffersen and Simutin basically proves our point. The authors argue that in an effort to beat benchmarks, fund managers tend to increase their exposure to high-risk stocks, while aiming to maintain tracking errors around the benchmark.
They conclude that their findings support theoretical conjectures that benchmarking can lead managers to tilt their portfolio toward high-risk stocks and away from low-risk stocks, causing high-risk stocks to become overpriced and low-risk stocks to become underpriced. This is consistent with the empirical finding of a flat (or even inverted) relation between risk and return; a result which is commonly referred to as the low volatility anomaly.
1Blitz & van Vliet, “The Volatility Effect: Lower Risk Without Lower Return”, Journal of Portfolio Management, Vol. 34, No. 1, 2007, pp. 102-113.
2Christoffersen & Simutin, “On the Demand for High-Beta Stocks: Evidence from Mutual Funds”, Review of Financial Studies, Vol. 30 No. 8, 2017, pp. 2596-2620. No. 8, 2017, pp. 2596-2620.
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