Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly

26 Pages Posted: 6 Apr 2010 Last revised: 10 Sep 2013

See all articles by Malcolm P. Baker

Malcolm P. Baker

Harvard Business School; National Bureau of Economic Research (NBER)

Brendan Bradley

Acadian Asset Management Inc., USA

Jeffrey Wurgler

NYU Stern School of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: March 2010

Abstract

Over the past 41 years, high volatility and high beta stocks have substantially underperformed low volatility and low beta stocks in U.S. markets. We propose an explanation that combines the average investor's preference for risk and the typical institutional investor’s mandate to maximize the ratio of excess returns and tracking error relative to a fixed benchmark (the information ratio) without resorting to leverage. Models of delegated asset management show that such mandates discourage arbitrage activity in both high alpha, low beta stocks and low alpha, high beta stocks. This explanation is consistent with several aspects of the low volatility anomaly including why it has strengthened in recent years even as institutional investors have become more dominant.

Suggested Citation

Baker, Malcolm P. and Bradley, Brendan and Wurgler, Jeffrey A., Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly (March 2010). NYU Working Paper No. 2451/29593, Available at SSRN: https://ssrn.com/abstract=1585031

Malcolm P. Baker

Harvard Business School ( email )

Boston, MA 02163
United States
617-495-6566 (Phone)

HOME PAGE: http://www.people.hbs.edu/mbaker

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Brendan Bradley

Acadian Asset Management Inc., USA ( email )

Jeffrey A. Wurgler (Contact Author)

NYU Stern School of Business ( email )

Stern School of Business
44 West 4th Street, Suite 9-190
New York, NY 10012-1126
United States
212-998-0367 (Phone)
212-995-4233 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~jwurgler/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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