Reversal Patterns in Risk-Adjusted Returns: Evidence of Excess Volatility in Anomalies

Abstract

According to the no-arbitrage condition, risk-adjusted returns should be unpredictable. Using several prominent factor models and a large cross-section of anomalies, we find that past cumulative risk-adjusted returns negatively predict future anomaly returns. We interpret these cumulative returns as deviations of an anomaly price from the value implied by the given factor model, introducing a novel anomaly-specific predictor endogenous to any test asset-factor model combination. The observed reversal pattern in risk-adjusted returns is consistent with a transitory component in prices, suggesting excess volatility in anomaly prices beyond what can be attributed to discount rate dynamics implied by standard factor models.

Keywords: Factor Models, Return Predictability, Mispricing, Reversal, Excess Volatility

JEL Classification: C38, G12, G17