Time-Varying Leverage Demand and Predictability of Betting-Against-Beta

Abstract

The leverage aversion theory implies that returns to the betting-against-beta (BAB) strategy are predictable by past market returns: An outward shift in investors' aggregate demand function simultaneously increases market prices and increases the expected future BAB return. I confirm the prediction empirically and find that the BAB strategy performs better in times when and in countries where past market returns have been high. I construct timing-strategies that are long BAB half the time and short BAB half the time, based on past market returns, and show that these timing strategies have realized strong historical performance.

Keywords: Asset Pricing, Leverage Constraints, Factor Timing, BAB

JEL Classification: G12, G14, G15