Journal of Investment Strategies

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

Longchong Chen, Jun Gao and Sheng Zhu

  • Stock investment portfolios with lower short-term volatility tend to yield higher abnormal returns after controlling for momentum and Fama and French (2015) risk factors.
  • There exits high volatility persistence in the US stock market especially at the 1-month ahead level indicating changes to constituent company stocks in the top and bottom deciles of volatility mimicking portfolios are minimal.
  • Best-performing equity mutual funds and corporate bond funds in terms of risk-adjusted returns generally have higher ‘long-term’ (as opposed to ‘short-term’) volatility above the market level.

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.

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