Some argue that the increased practice for active managers to measure performance against a benchmark has fueled the distortion between low volatility and riskier stocks, which has created the so-called risk-return anomaly.
“This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation exposes managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative relationship between risk and return because they raise the volatility of overvalued assets,” according to a research paper by Paul Woolley and Dmitri Vayanos of the London School of Economics and Andrea Buffa of Boston University.
Paul Woolley and Dmitri Vayanos of the London School of Economics and Andrea Buffa of Boston University point out that the disparity between low-volatility and risky stocks appears when active managers underweight positions in stocks with large weights in an underlying index and volatile prices. If a stock doubles in price while the investor is half-weight, the disparity compared to the index doubles, whereas if the manager is double-weighted and the price halves, the mismatch is also halved. Consequently, active managers have an incentive to overweight large and risky securities.
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Max Chen contributed to this article.