Do Limits to Arbitrage Explain the Benefits of Volatility-Managed Portfolios?
39 Pages Posted: 18 Dec 2017 Last revised: 31 Oct 2019
Date Written: April 3, 2018
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: Suggested Citation