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The Case for High-Volatility Stocks

The surprising power of the short interest signal.

John Rekenthaler, 06/20/2014

More Is More
Low-volatility investing is fashionable. The tactic has spread from its original field of U.S. equities to foreign stocks, bonds, and other asset classes. Morningstar now tracks 14 exchange-traded funds that follow low-volatility strategies. 

Low-volatility investing entails buying the tamest securities within a given investment sector. The logic is that investors are risk-averse when conducting asset allocation. Once their allocation is set, though, investors tend to prefer risk, as they seek to maximize returns for each asset class, and (per standard investment theory) they figure that the securities with relatively high volatility have relatively higher expected returns. They prefer risk so much that they overpay for higher-volatility issues. Which makes the neglected, seemingly dull securities the better investment bet.  

Two professors offer a new take on this narrative. In The Long and Short of the Vol Anomaly (jargon alert!), Bradford Jordan and Timothy Riley examine U.S. stock-market returns from 1991 to 2012 and affirm that, yes, low-volatility stocks did outgain their higher-volatility peers. 



But wait, there's more. It turns out that high-volatility stocks, like the little girl with the curl, have two moods. They are either very, very good--better than low-volatility stocks, in fact--or they are horrid. 

The mood's indicator is the level of short interest. The authors find short sellers to excellent forecasters. With both low- and high-volatility stocks, securities that have relatively low levels of short interest* outgain securities that have high levels of short interest. The effect is modest with low-volatility stocks but not so with high-volatility securities, where short interest carries a very strong signal. It's so strong, in fact, that high-volatility stocks with low levels of short interest gain the most.

(*The authors measure the level of short interest as the raw dollar amount of short interest in a stock divided by that stock's average daily trading volume. This calculation is called "days to cover.") 

is vice president of research for Morningstar.

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