The low-volatility anomaly is often attributed to limits to arbitrage, such as leverage, short-selling and benchmark constraints. One would therefore expect hedge funds, which are typically not hindered by these constraints, to be the smart money that is able to benefit from the anomaly. This paper finds that the return difference between low- and high-volatility stocks is indeed a highly significant explanatory factor for aggregate hedge fund returns, but with the opposite sign, i.e. hedge funds tend to bet not on, but against the low-volatility anomaly. This finding suggests that limits to arbitrage are not the key driver of the low-volatility anomaly and that concerns about low-volatility having become an ‘overcrowded’ trade may be exaggerated. Another contribution of this study is that it identifies a new, highly significant explanatory factor for hedge fund returns.

Keywords: Low-Volatility Anomaly, Low-Beta Anomaly, Betting against Beta, Limits to Arbitrage, Hedge Funds, Factor Investing

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