The Volatility Puzzle of the Low-Risk Anomaly

45 Pages Posted: 12 Jul 2021 Last revised: 20 Jul 2021

See all articles by Pedro Barroso

Pedro Barroso

CATÓLICA-LISBON School of Business & Economics

Andrew L. Detzel

University of Denver - Daniels College of Business

Paulo F. Maio

Hanken School of Economics - Department of Finance and Statistics

Date Written: June 27, 2021

Abstract

The volatility of betting-against-beta (BAB) and -idiosyncratic volatility (BAV) factors negatively forecasts their respective Sharpe ratios and abnormal returns. This predictability causes significant performance gains from volatility timing these factors and provides new time-series evidence on leading theories of the low-risk anomaly. Consistent with the limits-to-arbitrage theory, we show that the abnormal returns of the volatility-managed BAV strategy are concentrated in overpriced stocks. However, controlling for mispricing, arbitrage risk, lottery demand, and multiple risk factors has no effect on the timing benefits of BAB. We further show that the leverage constraints model predicts a counterfactual positive relation between volatility and subsequent BAB Sharpe ratios, and highly active institutions shift from high- to low-beta stocks as volatility increases, suggesting their demand contributes to the abnormal returns of BAB. Overall, the predictive power of volatility challenges our current understanding of the low-risk anomaly.

Keywords: Betting-against-beta, time-varying risk, realized volatility, risk factors, scaled factors, anomalies, lottery preferences, leverage constraints

JEL Classification: G11, G12, G17

Suggested Citation

Barroso, Pedro and Detzel, Andrew L. and Maio, Paulo F., The Volatility Puzzle of the Low-Risk Anomaly (June 27, 2021). Available at SSRN: https://ssrn.com/abstract=3882108 or http://dx.doi.org/10.2139/ssrn.3882108

Pedro Barroso (Contact Author)

CATÓLICA-LISBON School of Business & Economics ( email )

Palma de Cima
Lisbon, Lisboa 1649-023
Portugal

HOME PAGE: http://https://clsbe.lisboa.ucp.pt/person/pedro-monteiro-e-silva-barroso

Andrew L. Detzel

University of Denver - Daniels College of Business ( email )

2101 S. University Blvd
Denver, CO 80208
United States

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

Paulo F. Maio

Hanken School of Economics - Department of Finance and Statistics ( email )

FI-00101 Helsinki
Finland

HOME PAGE: http://sites.google.com/site/paulofmaio/home

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