Larry,
Yes, the short-interest anomaly is a powerful one. Perhaps you can point me to the low short interest ETF? I'm not aware that one exists. For someone picking their own stocks, it's a good indicator to use. Regardless, I don't see how the short-interest anomaly is a problem for low vol. So, short-interest is a more powerful indicator for beating the market than is low vol. I agree 100%. As noted, my interest here is not in beating the market. And there aren't that many stocks with low volatility and high short interest regardless. Certainly you could juice-up your low vol. returns (or the returns of any other factor strategy) by incorporating short interest as well. When the ETF that does that comes to market, I know I'll take a look!
I agree that valuation matters. I've said so in every thread we've had on this topic. A couple of years ago low. vol. portfolios were priced at 20% premium to the market, which definitely caused me to pause. Now it's more like 5%, which I'm comfortable with.
Again, low vol. stocks have provided very close to the market return with significantly less volatilty. The MSCI index which Robert T refers to at the beginning of the thread has provided identical returns to the overall MSCI USA index since inception (5/1988). Of course, it's a backtested index, so caution is always warranted. However, low vol. backtests generally show returns equal to or a little less than the market over time with [obviously] lower volatility.
I get that idea that you are looking to beat the market by the rest of your paragraph. If you pick the "best" stocks, you can either get higher portfolio performance or you can then add more bonds and get the same performance with less risk. Either way, the key to the strategies you promote is to pick equities that will beat the market. As a value tilter, I have no objection to that!
Finally, as you know I'm not particularly persuaded by risk-based explanations of any of the anomalies we talk about, as the notion that risky=all but guaranteed to beat the market makes no sense to me. We've hashed through that before and I seem to be a minority on that count, so those who are more interested can just search old threads.
Jaab--
Actually, Falkenstein doesn't really argue that low vol is a free lunch. Instead, he argues that it seems anomalous because of most in academic finance misunderstand risk (according to him). His argument is that risk is and is perceived to be relative. Happiness comes from being better off than your friends/neighbors etc. not from reaching some absolute level of accomplishment. In investing, this means that "risky" = failure to beat to the market. To avoid this risk, one must pick investments with higher potential payoffs--i.e. high volatility stocks. In this framework, risk and behavioral explanations mesh into one. His approach may or may not be correct (I'm not sure, personally), but it's interesting and his book, "The Missing Risk Premium" is worth a read for those who find such material interesting.