Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly

Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks

“…Our work provides a unified explanation for several empirical patterns extensively documented in the literature, including the relation between average returns and: price-earnings ratios (Rosenberg, Reid, and Lanstein, 1985;Basu, 1977;Haugen and Baker, 1996); market-to-book ratios and Tobin's Q (Fama and French, 1992;Lakonishok, Shleifer, and Vishny, 1994); investment rates (Titman, Wei, and Xie, 2004;Anderson and Garcia-Feijo, 2006); profitability (Fama and French, 2006;Novy-Marx, 2012); idiosyncratic return volatility Zhang, 2006, 2009); as well as the fact that the security market line is weakly downward sloping (Black, Jensen, and Scholes, 1972;Frazzini and Pedersen, 2010;Baker, Bradley, and Wurgler, 2011;Hong and Sraer, 2012).…”

“…The difficulty of existing models with production in reproducing the negative relation between market betas or idiosyncratic volatility and future returns has led to several recent candidate explanations based on market frictions (e.g., Frazzini and Pedersen, 2010;Baker et al, 2011;Hong and Sraer, 2012) or incomplete information (e.g. Armstrong, Banerjee, and Corona, 2012).…”

The Low-Risk Anomaly: A Decomposition into Micro and Macro Effects

“…In terms of constraints, Black (1972) and Frazzini and Pedersen (2010) emphasized leverage. Karceski (2002) and Baker et al (2011) focused on the effects of intermediation. Whereas Karceski described the interaction between highbeta strategies and the capture of mutual fund flows, Baker et al derived the implications of fixed-benchmark strategies for low-risk stocks using the framework in Brennan (1993).…”

“…Baker et al (2011) surveyed three behavioral explanations: lottery preferences, representativeness, and overconfidence. We omit a detailed review of these explanations here to save space.…”

“…In the context of the low-risk anomaly, Baker, Bradley, and Wurgler (2011) emphasized the important constraint that long-only, fixed-benchmark mandates impose on micro arbitrage. Many institutional investors are judged not by total return relative to total risk but instead by active return relative to active risk, or benchmark tracking error.…”