Uncertainty and the Beta Anomaly

Abstract

Using various indices of economic and financial uncertainties, we document a new stylized fact about the beta anomaly: the negative relation between beta and alpha exists in low-uncertainty periods but not in high uncertainty periods. We show that this finding cannot be explained by sentiment, lottery preference, coskewness risk, or funding constraints. We hypothesize that high uncertainty reduces investors’ appetite for high-beta stocks, which increases their expected returns and restores the CAPM relation. Consistent with this hypothesis, mutual fund flows are negatively related to fund beta when uncertainty is high, and trade-induced changes in market risk exposure of actively-managed funds are negatively correlated with uncertainty. Furthermore, the negative beta-alpha relation is attenuated by firm-level uncertainty.

Keywords: Uncertainty; ambiguity; beta anomaly; stock returns

JEL Classification: G12; G14