Can Investor Sentiment Explain the Abnormal Returns of Volatility-Managed Portfolio Strategy? Evidence from the Chinese Stock Market

Jie Zhou, Wei-Qi Liu and Jian-Ying Li

Emerging Markets Finance and Trade, 2024, vol. 60, issue 13, 2907-2937

Abstract: This study develops a theoretical model to capture volatility-managed portfolios’ risk-adjusted returns affected by investor sentiment, and uses Chinese A-share market data to analyze the volatility-managed effect based on the small-minus-big (SMB) factor and explain the abnormal returns of volatility-managed portfolios from the investor sentiment perspective. Our results show that the Sharpe ratio of the SMB factor significantly increases after volatility management, especially in low-sentiment periods. Moreover, the mechanism analysis shows that in low-sentiment periods, small-cap stock investors overreact to volatility compared to large-cap stock investors, making the SMB factor significantly positively correlated with lagged volatility. Additional analyses show that volatility-managed portfolios constructed through stocks with gambling characteristics can achieve higher abnormal returns, and the abnormal returns of volatility-managed portfolios cannot be corrected by arbitrage traders as arbitrage is ineffective, reflecting the immaturity of China’s emerging capital market.

Date: 2024
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DOI: 10.1080/1540496X.2024.2336064

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