Betting Against Correlation: Testing Theories of the Low-Risk Effect

Asness, Clifford S.; Frazzini, Andrea; Gormsen, Niels Joachim; Pedersen, Lasse Heje

doi:10.2139/ssrn.2913508

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Betting Against Correlation: Testing Theories of the Low-Risk Effect

73 Pages Posted: 8 Feb 2017 Last revised: 21 Jun 2018

See all articles by Clifford S. Asness

Niels Joachim Gormsen

University of Chicago - Booth School of Business

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; Centre for Economic Policy Research (CEPR)

There are 2 versions of this paper

Date Written: January 31, 2016

Abstract

We test whether the low-risk effect is driven by (a) leverage constraints and thus risk should be measured using beta vs. (b) behavioral effects and thus risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, where only volatility is related to idiosyncratic risk. We introduce a new betting against correlation (BAC) factor that is particularly suited to differentiate between leverage constraints vs. lottery explanations. BAC produces strong performance in the US and internationally, supporting leverage constraint theories. Similarly, we construct the new factor SMAX to isolate lottery demand, which also produces positive returns. Consistent with both leverage and lottery theories contributing to the low-risk effect, we find that BAC is related to margin debt while idiosyncratic risk factors are related to sentiment.

Keywords: asset pricing, leverage constraints, lottery demand, margin, sentiment

JEL Classification: G02, G12, G14, G15

Suggested Citation: Suggested Citation

Asness, Cliff S. and Frazzini, Andrea and Gormsen, Niels Joachim and Pedersen, Lasse Heje, Betting Against Correlation: Testing Theories of the Low-Risk Effect (January 31, 2016). Available at SSRN: https://ssrn.com/abstract=2913508 or http://dx.doi.org/10.2139/ssrn.2913508