Is volatility a friend or enemy of your stock and fund investments?

Longchong Chen, Jun Gao and Sheng Zhu

Abstract

Our study investigates the role of past volatility in the cross section of returns on US stocks, equity mutual funds and corporate bond funds. We analyze the predictive power of realized volatility, value-at-risk and idiosyncratic risk with respect to the future performance of the three types of investment. In addition, we specifically examine the different roles of short- and long-term volatility in mutual fund returns (ie, for equity funds and corporate bond funds). Our findings indicate that, for equity-related investments, portfolios with lower short-term volatility generally yield higher abnormal returns after controlling for market, size, value, profitability and investment pattern risk factors. However, over the long term, the best-performing equity funds usually have higher volatility than the market level. We also discover that neither low-volatility nor high-volatility corporate bond funds exhibit significant risk-adjusted returns in the short term, while bond mutual funds with higher volatility over the long term usually yield higher alphas on average.