Stocks with high volatility should yield high expected return. This is one of the most fundamental principles in finance. However, a wide strand of empirical evidence has put this concept on trial, showing that quite often the opposite is true – low volatility stocks have historically outperformed high volatility stocks. The most common explanation revolves around behavioral biases such as attention-grabbing bias, representativeness bias, overconfidence, and preference for lotteries.
No study available investigating this well-known asset pricing anomaly in the cryptocurrency market.
This is particularly surprising given the mounting interest in factor risk premia in general and cryptocurrency factors in particular. Tobias Burggraf and Prof. Dr. Markus Rudolf have set forth to fill this gap in a recent study. Therefore, long-short portfolios on a sample of 1,000 cryptocurrencies for the 2013 – 2019 period have been built in the following way:
- Sort all cryptocurrencies by their cumulative past volatility in an increasing order into deciles
- Build long and short portfolios consisting of the top and bottom cryptocurrencies
- Calculate the performance of the respective long-short portfolio
This approach allows to study the cross-section of cryptocurrencies and better isolate low volatility loadings.
The popular low volatility strategy does not work in the cryptocurrency markets.
The results even indicate worse, in fact the low volatility strategy generates negative returns in the cryptocurrency markets. It is assumed that the discrepancy between the study results and those for traditional asset classes is attributable to the uniqueness of the cryptocurrency market and is a combination of behavioral biases and the absence of large institutional investors. Therefore, the explanation for the disappearance of the low volatility anomaly follows the causal chain:
- The capital asset pricing model (CAPM) assumes that investors only care about absolute return. In reality, the mandates of institutional investors are often linked to beating the market, making low-volatility investments relatively unattractive for benchmark-relative investors because they involve high tracking error and lower expected return. However, because the cryptocurrency market is dominated by retail investors and therefore by absolute-return oriented investors, the Security Market Line (SML) flattening as documented in Brennan et al. (2012) is less pronounced than in other markets.
- Profit-maximizing asset managers typically have an incentive to attract investor flows by investing in assets with high idiosyncratic volatility. This effect is reinforced by either small, young, or bad performing funds trying to attract capital by investing in riskier, lottery-like assets. Again, because institutional investors and asset managers are underrepresented in the cryptocurrency market, this agency issue documented for more mature markets is less relevant.
The results provide important information to a variety of stakeholders including investors and policymakers. The results indicate that cryptocurrencies are more efficient than previous studies have suggested, and that higher volatility yields higher return. This has important practical implications. Specifically, investors may use this information for portfolio allocation purposes. Policy makers could take this study as an indication that some rules that apply in traditional stock markets do not apply in cryptocurrency markets.
Please refer to the original paper for further details:
Brennan, M.J., X. Cheng, and F. Li (2012). Agency and institutional investment. European Financial Management 18(1), 1–27.