Alpha factors and signals
Low-volatility and other factors
3 min
A handful of further factors complete the classic toolkit, the most counter-intuitive of which deserves a close look.
The low-volatility anomaly
Plain finance theory says higher risk should earn higher return. Empirically, the opposite has often held: portfolios of low-volatility, boring stocks have delivered better risk-adjusted returns than high-volatility, exciting ones. This is the low-volatility anomaly, and it is one of the most persistent puzzles in finance.
The leading explanation is behavioural and structural: investors overpay for the lottery-like upside of volatile 'story' stocks, and many large funds are barred from using leverage so they reach for risk by buying volatile names instead — bidding them up and depressing their returns.
Size and carry
- Size — historically, smaller companies outperformed larger ones (the small-cap premium), though it has been weaker and less reliable in recent decades.
- Carry — earning the yield differential between assets, most associated with currencies (borrow a low-rate currency, hold a high-rate one). Carry tends to pay steadily and then lose a great deal very fast in a crisis — a classic 'picking up coins in front of a steamroller' profile.
The meta-lesson
Each factor has a story, a body of evidence, and a regime where it fails badly. None works all the time. That is not a flaw to be engineered away — it is exactly why the premia survive: a factor that always worked would be arbitraged to nothing instantly. Durable factors are the ones investors find hard to hold through their bad years.
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