eThesis - Kauppakorkeakoulun sähköiset gradut

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PURPOSE OF THE STUDY:

The purpose of this thesis is to provide further evidence on the low volatility anomaly by examining its existence during the period from 1974 to 2013 as well as during defined periods of rising and declining stock markets. This thesis clarifies whether low volatility stocks outperform high volatility stocks in absolute return terms, or only in risk-adjusted return terms. Furthermore, this thesis studies whether there is an excess demand for high volatility stocks, a potential reason for the anomaly, by examining U.S. equity mutual funds and mutual funds' allocations. In particular, this thesis examines whether an average portfolio manager has an overweight in high volatility stocks relative to the market portfolio, and additionally, an underweight in low volatility stocks.

DATA AND METHODOLOGY:

The data used to examine the low volatility anomaly and mutual fund holdings is sourced from several sources within the WRDS database. My sample comprises common stocks listed on the NYSE, AMEX and NASDAQ during the period from 1973 to 2013 consisting of 4,266 stocks on average per month. I calculate historical monthly volatilities for the stocks, and every month, sort the stocks in an ascending order into deciles based on the historical volatilities. I calculate the performance of these decile portfolios and study the relationship between volatility and expected return. The CRSP mutual fund holdings data comprises U.S. mutual fund holdings reports from 2002 to 2013. I include funds that have 80% to 100% of their total net assets invested in U.S. equities. I examine funds' exposures to the sorted volatility deciles and compare the exposures to the construction of the market portfolio to determine the relative weights in low and high volatility stocks.

RESULTS:

The results indicate that low volatility stocks offer clearly higher risk-adjusted returns, measured as the Sharpe ratio, and significantly higher alphas than high volatility stocks. The bottom volatility decile also outperform the top volatility decile in absolute return terms. Furthermore, Sharpe ratios are almost monotonously decreasing with volatility. However, volatility and absolute returns are positively related except for the highest volatility deciles, for which the absolute returns are decreasing with volatility. On average, U.S. mutual funds have a moderate overweight in high volatility stocks and a significant underweight in low volatility stocks. Therefore, a moderate excess demand for high volatility stocks and a notable demand shortage for low volatility may actually be the underlying reason why the anomaly exists.