Do Limits to Arbitrage Explain the Benefits of Volatility-Managed Portfolios?

39 Pages Posted: 18 Dec 2017 Last revised: 31 Oct 2019

See all articles by Pedro Barroso

Pedro Barroso

UNSW Australia Business School, School of Banking and Finance

Andrew L. Detzel

University of Denver - Daniels College of Business

Date Written: April 3, 2018

Abstract

We investigate whether transaction costs, arbitrage risk, and short-sale constraints explain the abnormal returns of volatility-managed equity portfolios. Even using five cost-mitigation strategies, after accounting for transaction costs, volatility management of common asset-pricing factors besides the market return generally produces zero abnormal returns and significantly reduces Sharpe ratios. In contrast, abnormal returns of the volatility-managed market portfolio are profitable after transaction costs and concentrated in the most easily arbitraged stocks, those with low arbitrage risk and short-sale constraints. Moreover, the managed-market strategy only provides superior performance when sentiment is high, consistent with prior theory that sentiment traders under-react to volatility.

Keywords: Volatility-managed portfolios, limits to arbitrage, anomalies

JEL Classification: G11, G12, G14

Suggested Citation

Barroso, Pedro and Detzel, Andrew L., Do Limits to Arbitrage Explain the Benefits of Volatility-Managed Portfolios? (April 3, 2018). Available at SSRN: https://ssrn.com/abstract=3088828 or http://dx.doi.org/10.2139/ssrn.3088828

Pedro Barroso

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia

Andrew L. Detzel (Contact Author)

University of Denver - Daniels College of Business ( email )

2101 S. University Blvd
Denver, CO 80208
United States

HOME PAGE: http://portfolio.du.edu/adetzel

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