DP11531 | The Booms and Busts of Beta Arbitrage

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Low-beta stocks deliver high average returns and low risk relative to high-beta stocks, an opportunity for professional investors to “arbitrage” away. We argue that beta-arbitrage activity instead generates booms and busts in the strategy’s abnormal trading profits. In times of low activity, the beta-arbitrage strategy exhibits delayed correction, taking up to three years for abnormal returns to be realized. In stark contrast, when activity is high, prices overshoot as short-run abnormal returns are much larger and then revert in the long run. These cyclical patterns also show up in hedge fund exposures to beta arbitrage, particularly exposures of smaller and thus more nimble funds, and can be linked to the past performance of the strategy. We document a novel positive-feedback channel operating through firm-level leverage that facilitates these boom and bust cycles.