Smart money is blindsided by a flaw of its own making hiding in plain sight -- an investing maxim quants have known for an age.

Blame bets on volatility.

Research from Robeco Asset Management’s David Blitz concludes hedge funds have hitched their wagon to stocks with large equity-price swings -- a misguided strategy over the long haul.

Not only have high-volatility shares massively underperformed low-vol peers, this outsized exposure to the high-octane cohort is one of the strongest explanations for hedge-fund performance, according to Blitz.

The sweeping study crunched industry returns from 2000 to 2016, and concluded funds overall have negative exposure to a long-short version of low volatility.

“The fact that hedge funds are positioned like investors in high-volatility stocks, this does not contribute positively to their returns,” the Rotterdam-based head of quantitative equity research said in an interview. “They would likely have been better off if they had chosen not to bet against the low-volatility anomaly."

A tilt away from the low-volatility factor ranks among the top three drivers of fast-money performance, alongside the broader index itself and emerging-market exposures, according to Blitz.

Efforts to deconstruct active-manager returns are in part the founding principle behind factor investing, one of the most popular quantitative strategies -- with Blitz a key proponent of the low-vol variety.

Academics have long discovered that most equity alpha is extracted from sources other than bets on the prospects of an individual company. Rather, successful managers pick stocks that share common factors, like momentum or earnings growth, that reliably beat the market over time.

From there, the low-volatility factor was born. Today, it’s a booming industry. Along with its inclusion in factor funds offered by Robeco and other quant giants like AQR Capital Management, smart beta exchange-traded funds focused on the investing style have $53 billion in assets.

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