The Volatility Puzzle of the Low-Risk Anomaly
45 Pages Posted: 12 Jul 2021 Last revised: 20 Jul 2021
Date Written: June 27, 2021
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: Suggested Citation