The booms and busts of beta arbitrage

Dong Lou, Christopher Polk and Shiyang Huang

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: Historically, low-beta stocks deliver high average returns and low risk relative to high-beta stocks, offering a potentially profitable investment opportunity for professional money managers to "arbitrage" away. We argue that beta-arbitrage activity instead generates booms and busts in the strategy's abnormal trading profits. In times of relatively little activity, the beta-arbitrage strategy exhibits delayed correction, taking up to three years for abnormal returns to be realized. In stark contrast, in times of relatively-high activity, short-run abnormal returns are much larger and then revert in the long run for the stocks in question. Importantly, we document a novel positive feedback channel operating through firm-level leverage that facilitates these boom and bust cycles. Namely, when arbitrage activity is relatively high and beta-arbitrage stocks are relatively more levered, the cross-sectional spread in betas widens, resulting in stocks remaining in beta-arbitrage positions significantly longer with short-run abnormal returns more than tripling in value. Our findings are exclusively in stocks with relatively low limits to arbitrage (large, liquid stocks with low idiosyncratic risk), consistent with excessive arbitrage activity destabilizing prices.

JEL-codes: G00 G12 G14 G23 (search for similar items in EconPapers)
Pages: 55 pages
Date: 2014-12-01
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Downloads: (external link)
http://eprints.lse.ac.uk/119019/ Open access version. (application/pdf)

Related works:
Journal Article: The Booms and Busts of Beta Arbitrage (2024)
Working Paper: The booms and busts of beta arbitrage (2023)
Working Paper: The Booms and Busts of Beta Arbitrage (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:119019

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