The Limits to Arbitrage and the Low-Volatility Anomaly

The authors found that over 1963–2010, the existence and trading efficacy of the low-volatility stock anomaly were more limited than widely believed. For example, they found no anomalous returns for equal-weighted long–short (low-risk minus high-risk) portfolios and that alpha is largely eliminated when omitting low-priced stocks from value-weighted long–short portfolios. Furthermore, performance of long–short portfolios was significantly reduced by high transaction costs, reflecting the finding that the abnormal returns were concentrated among low-liquidity and smaller stocks. Amplifying liquidity needs, the anomalous excess returns quickly reversed, requiring frequent rebalancing. The authors’ findings have meaningful implications for implementing low-risk equity portfolio strategies.