Value and Size are common strategies based on the higher-than-average return to value and small cap stocks, and one can mention the value or size 'factor' that presumably causes this to happen without much explanation. It's a 'risk' factor to many, because small cap and value stocks generate statitical out-performance, which can only persist if there is risk associated with it. As to what the risk of small cap and value stocks is, no one really knows. At first, it was thought to be financial distress risk, but then we discovered such firms have low returns when you measure distress directly, so that's not it. It's not volatility, or beta.
While I'm skeptical there's a good risk factor story for value and size, there's something intuitively spookier about value and small caps vs. their opposites, so I wouldn't shut the door on that.
In contrast, attempts to explain the low vol premium as a risk factor are like a socialist explaining the Stalin-Hitler pact, convoluted and unconvincing. A paper by Li, Sullivan, and García-Feijóo on the SSRN looks at the feasibility of trading the volatility anomaly. As with Baker, Bradley, and Taliaferro (2013), they focus on 'abnormal returns', which I don't find as informative as simple absolute returns for various reasons, so I wont get into what they considered their main result. Instead, I want to talk about their mention of why there's a low volatility premium. Here's the first suggested explanation they offer for the existence of the low volatility anomaly:
Should the anomaly be related to systematic risk, then the excess returns can be viewed as arising from some, as of yet unknown, common risk actor(s). For instance, Merton (1987) offers an explanation for why investors would demand higher returns for taking on higher IVOL.This is funny. They suggest one theory is that volatility demands a premium because it's risky when it's low (presumably, the CAPM beta holds as well, generating high and low risk to volatility as a factor, which, when you add a preference positive skew and aversion to negative skew, implies a great deal of nuance). Then they reference Merton, who's hypothesized back in the old days (1987) that idiosyncratic volatility was positively related to risk because idiosyncratic volatility should contain a lot of mismeasured risk factors. As a potential taste of why the low volatility anomaly exists, its not promising because it's got the wrong sign.
Then they mention Ang, Hodrick, and Xing and Zhang (2009), who note the international dimension of this puzzle suggests perhaps a pervasive risk factor (they were really that tentative) That is, low volatility did relatively well in the 2008 crash, relatively poorly in the 2009 rebound, worldwide, so, it's correlated internationally, which means there's potentially a risk factor that they are all reacting to. Just to be clear, the Low Vol 'risk factor' went down a lot in 2008, and was really high for most of 2009, which I guess means the low vol risk factor is like the two-slit experiment in quantum physics: if you think you understand it, you don't understand it. .
I guess they were simply trying to survey prominent outstanding explanations, but I think this is like introducing your new theory on influenza with an overview of the various goblins hypothesized to cause colds. And indeed Li, Sullivan and García-Feijóo prefer their own new theory of market mispricing, which though in working paper since 2010 isn't on the internet, so who knows. Interestingly, while they mention Black (1972), making one think, this is a leverage story, they then mention Wurgler, Baker, and Bradley (2011) and only mention Asness and/or Frazzini and Pedersen in a different context, implying, they really think it's not a leverage story, just some, well, mispricing story that's affected by all the things that keep rational people doing what economists think they should want to do.
I'll keep an open mind until I read it.