Low volatility anomalies - Is it all about the skew?

There is no free lunch. The idea that you can form a low volatility portfolio and get added return or alpha is false once you take into account higher moments like skew. The low volatility or low beta portfolio is not so safe once you account for skew or tail risk. This idea is presented in the well-researched paper "Low-Risk Anomalies" in the October 2020 Journal of Finance. 

If an idea seems to be too good to be true, that is, you get return without having to pay for it with risk, then it is likely to be wrong. It is just a matter of trying to find the risk and figure out the pricing.

This paper concludes that the low risk anomalies are just compensation for coskewness risk, the risk associated with the asset and the squared market return. More important, ex-ante option-implied skewness is related to ex-post residual coskewness. There are tools or measures that can be used to find the assets that are most likely to be affected by coskewness. 

The option-implied skewness can be found in measuring OTM call and puts. If there is a skew in the options associated with a firm, there will be a meaningful coskewness that can account for the alpha in a simple regression of market risk beta. The alpha from a 3-factor and 4-factor model can also be described by this coskewness factor.

If an investor controls or accounts for this coskewness, there is no significant alpha for betting against beta or betting against volatility. Investor may think they are getting extra return by holding these low volatility portfolios, but it is a mistake. 

The argument has been that high beta portfolios are mispriced because of such issues as leverage constraints but this coskewness evidence seems more compelling. We have discussed the low volatility effect, see The low volatility style factor - A great history, but can it continue? and Low volatility / Low beta performance - This smart beta edge has been real, but we did not discuss the issue of skew as an explanation.

Skewness is an important risk potentially priced in the markets. This research highlights the problem of using only one dimension of risk, standard deviation. When investors say that they need to focus on tail risk, here is a perfect way to practically approach the problem. Look for how skewness is not priced in the market. This work does not mean that all low volatility investing should be avoided. It does mean that you are getting paid to take risk not associated with volatility. If you are comfortable with this skew risk, then take it. If you have not thought about it, then avoid the low-risk anomaly.