Professor Christopher Polk, London School of Economics and CEPR
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 realised. In stark contrast, in times of relatively-high activity, short-run abnormal returns are much larger and then revert in the long run.
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. Our findings are exclusively in stocks with relatively low limits to arbitrage (large, liquid stocks with low idiosyncratic risk), consistent with excessive arbitrage activity destabilising prices.
Christopher Polk is Professor of Finance and Director of the Financial Markets Group (FMG) at the London School of Economics. His research interests include asset pricing, corporate finance, hedge funds and macroeconomics.