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Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly

Last Updated on 10 February, 2024 by Rejaul Karim

In the intricate world of financial markets, the Low Volatility Anomaly has stood as a perplexing puzzle for over four decades. Spanning 26 pages, this work by Malcolm P. Baker, Brendan Bradley, and Jeffrey Wurgler delves into the anomaly’s roots, proposing a nuanced perspective that intertwines the average investor’s risk preference with institutional investors’ strategic mandates.

Exploring the interplay between volatility, beta, and stock performance in the U.S. market, the paper introduces a compelling thesis — that institutional investors, driven by benchmark constraints, inadvertently hinder arbitrage in both high alpha, low beta, and low alpha, high beta stocks.

As the anomaly’s enigma deepens over the years, this research offers an insightful lens into its evolution amid the dominance of institutional players.

Abstract Of Paper

Over the past 41 years, high volatility and high beta stocks have substantially underperformed low volatility and low beta stocks in U.S. markets. We propose an explanation that combines the average investor’s preference for risk and the typical institutional investor’s mandate to maximize the ratio of excess returns and tracking error relative to a fixed benchmark (the information ratio) without resorting to leverage. Models of delegated asset management show that such mandates discourage arbitrage activity in both high alpha, low beta stocks and low alpha, high beta stocks. This explanation is consistent with several aspects of the low volatility anomaly including why it has strengthened in recent years even as institutional investors have become more dominant.

Original paper – Download PDF

Here you can download the PDF and original paper of Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly.

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Author

Malcolm P. Baker
Harvard Business School; National Bureau of Economic Research (NBER)

Brendan Bradley
Acadian Asset Management Inc., USA

Jeffrey Wurgler
NYU Stern School of Business; National Bureau of Economic Research (NBER)

Conclusion

Malcolm P. Baker, Brendan Bradley, and Jeffrey Wurgler delve into the enduring mystery of the low volatility anomaly in U.S. markets over four decades. Their insight reveals a convergence of investor risk preferences and institutional mandates, shaping the consistent outperformance of low volatility and low beta stocks.

The clash arises from institutional goals optimizing returns relative to fixed benchmarks, limiting arbitrage activities in specific stock categories. This explanation harmonizes with the anomaly’s growing strength, especially as institutional influence rises.

The research not only demystifies the anomaly’s persistence but also anticipates its endurance, emphasizing the delicate interplay between investor behavior and institutional strategies.

Related Reading:

The Low-Volatility Anomaly: Market Evidence on Systematic Risk versus Mispricing

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FAQ

Q1: What is the primary focus of the research conducted by Malcolm P. Baker, Brendan Bradley, and Jeffrey Wurgler on the Low Volatility Anomaly?

A1: The research explores the Low Volatility Anomaly observed in U.S. markets over four decades. It proposes an explanation that combines the average investor’s risk preference with the strategic mandates of institutional investors. The focus is on understanding how institutional goals, particularly optimizing returns relative to fixed benchmarks, contribute to the anomaly’s persistence.

Q2: How does the paper explain the underperformance of high volatility and high beta stocks compared to low volatility and low beta stocks?

A2: The explanation centers around institutional investors’ mandates to maximize the ratio of excess returns and tracking error relative to fixed benchmarks (information ratio) without using leverage. This mandate discourages arbitrage activity in both high alpha, low beta stocks, and low alpha, high beta stocks. The clash between investor risk preferences and institutional mandates contributes to the underperformance of high volatility and high beta stocks.

Q3: Why does the research anticipate the endurance of the Low Volatility Anomaly, especially in the context of growing institutional influence?

A3: The research anticipates the endurance of the anomaly by emphasizing the delicate interplay between investor behavior and institutional strategies. As institutional influence rises, their mandates continue to shape the consistent outperformance of low volatility and low beta stocks. The clash between investor risk preferences and institutional goals is expected to contribute to the anomaly’s persistence.

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