Do Limits to Arbitrage Explain the Benefits of Volatility-Managed Portfolios?
40 Pages Posted: 18 Dec 2017 Last revised: 5 Jun 2018
Date Written: April 3, 2018
We investigate whether limits to arbitrage explain the abnormal returns of volatility-managed portfolios. To the contrary, these abnormal returns are negligible in long-only portfolios consisting of hard-to-arbitrage stocks. Moreover, utility gains from volatility management are at least twice as high for out-of-sample mean-variance-efficient portfolios constructed from easy-to-arbitrage stocks than from hard-to-arbitrage stocks. These results contrast with the common finding that anomalies are stronger where arbitrage is difficult. We also show the abnormal returns of volatility-managed portfolios are only significant in times of high liquidity and sentiment, consistent with models where unsophisticated traders under-react to informed order flow in such times.
Keywords: Volatility-managed portfolios, limits to arbitrage, anomalies
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation