Can the portfolio excess growth rate explain the predictive power of idiosyncratic volatility?

Finance Research Letters, Wiley, December 21. Authors unveil a theoretical link between the portfolio excess growth rate (EGR) and two measures of average idiosyncratic volatility (IdVol) and confirm it empirically for the U.S. equity market. They find that the EGR and average IdVol are positively related with subsequent market returns over shor...
Author(s)
Daniel Mantilla-Garcia, Juliana Malagon, Julian R.Aldana-Galindo

Finance Research Letters, Wiley, December 21.

Authors unveil a theoretical link between the portfolio excess growth rate (EGR) and two measures of average idiosyncratic volatility (IdVol) and confirm it empirically for the U.S. equity market. They find that the EGR and average IdVol are positively related with subsequent market returns over short horizons.

A theoretical analysis of EGR properties explains why the relationship between average IdVol and future portfolio returns changes for different weighting schemes, horizons, and portfolio rebalancing frequencies.

Furthermore, it explains why the outperformance of low versus high IdVol portfolios is completely reversed at higher rebalancing frequencies when using equal weights.

 

Main results:

  • Excess Growth Rate (EGR) and idiosyncratic volatility (IdVol) have a direct link.
  • EGR and IdVol are positively related with future market returns over short horizons.
  • EGR properties explain why predictability varies with horizon and portfolio weights.
  • Return of high vs. low volatility EW portfolios is highly dependent on rebalancing.

 

Keywords

Idiosyncratic volatility puzzle, Return predictability, Cross-sectional variance, Excess growth rate

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