Step 2: Buy Low Volatility and Sell Short High Volatility
A recent paper by Lasse Pedersen of New York University and Andrea Frazzini of AQR Asset Management suggest that a strategy of betting against beta (i.e. buying low volatility stocks) and selling short high beta stocks “produces significant risk-adjusted returns.”4
Source: “Betting Against Beta” (A. Frazzini and L. Pedersen, 2011). Study of global stocks from 1964-2009. Betas are computed from 1-year daily excess returns. Stocks resorted and portfolios rebalanced monthly. Past performance is no guarantee of future results.
Their paper also addresses the question of why does this anomaly persist.
According to the academic theories such as the Capital Asset Pricing Model (CAPM), investors will always choose to own the stocks with the highest expected return per unit of risk (Sharpe Ratio) and then use leverage to suit their personal preference.
So if you are bullish on the market you simply increase your equity exposure either by switching from cash to equities or by borrowing additional money to invest (i.e. use leverage).
Additionally, according to the theory, the “smart money” (institutional investors) will always take the opposite side of the trade whenever an equity becomes over-priced or under-priced quickly removing the potential to profit from the imbalances. This is the basic tenet of the Efficient Market Hypothesis.
But markets do not always work this way in the real world.