Why Volatility-Sensitive Stocks May Earn Low Average Returns

# Why do stocks with high sensitivities to innovations in volatility have low average returns?


# Why do stocks with high sensitivities to innovations in volatility have low average returns?












Ang, Xing and Zhang (2006) state that "stocks with high sensitivities to innovations in aggregate volatility have low average returns". I am familiar that this question has been asked before in similar words (see What is meant by innovations in volatility?), however the answer was not very satisfying.

To me it seems counterunituitivecounter-intuitive that firms that have high sensitivity to market risk have lower average returns as argued from a risk based perspective. I understand that hedging demand of the particular stocks would lead them to have a negative stock premium however in market up-states, what I do not understand is: Why assets with high sensitivities to market volatility risk provide hedges against market downside risk?

If the stock 'produces' returns in the times when volatility is high (in market downturns) then it would make sense for investors to demand lower returns. However why do stocks with high sensitivity to volatility provide a hedge against volatility?

Hope to hear from you. Many thanks in advance

The paper in question: https://www.nber.org/papers/w10852.pdf

## Answer by phdstudent (score 3, accepted)

https://quant.stackexchange.com/a/47589

That's in finance what we call a puzzle. From their follow on paper (here), they rule out many different economic explanations for such a thing to happen:

> We conclude that the puzzle of why high idiosyncratic volatility stocks have low returns is a global phenomenon. Further research must investigate if there are true economic sources of risk behind the idiosyncratic volatility phenomenon causing stocks with high volatility to have low expected returns.

Few follow-on papers have tried to rationalize that. One finding is from this paper by Herskovic et al. (here)

> We show that firms' idiosyncratic volatility obeys a strong factor structure and that shocks to the common factor in idiosyncratic volatility (CIV) are priced. Stocks in the lowest CIV-beta quintile earn average returns 5.4% per year higher than those in the highest quintile. The CIV factor helps to explain a number of asset pricing anomalies. We provide new evidence linking the CIV factor to income risk faced by households. These three facts are consistent with an incomplete markets heterogeneous-agent model. In the model, CIV is a priced state variable because an increase in idiosyncratic firm volatility raises the average household's marginal utility. The calibrated model matches the high degree of comovement in idiosyncratic volatilities, the CIV-beta return spread, and several other asset price moments.

## Answer by AK88 (score 2)

https://quant.stackexchange.com/a/47590

I think the best source for the possible explanations of this anomaly is Ang's book. In there, he says:

> We are still searching for a comprehensive explanation for the risk anomaly. Inmy opinion, the true explanation is a combination of all of the explanations listed below, plus potentially others being developed.

- Data mining. Bali and Cakici (2008) and Han and Lesmond (2011) pointed out that the original findings are sensitive to portfolio weighting schemes and illiquidity effects.

- Leverage constraints. Investors that do not have access to leverage will simply hold stocks with high beta (to get some leverage presumably). This leads to higher prices and consequently lower returns.

- Agency problems. Benchmark trackers and investors that are restricted from short selling do not participate in capturing this alpha.

- Preferences. Some investors simply have preference for high beta, high volatility stocks. This may also drive the expected returns lower.

Overall, I think Chapter 10 of Ang's book is the place for more information.