Betting against correlation: Testing theories of the low-risk effect

We test whether the low-risk effect is driven by leverage constraints and, thus, risk should be measured using beta versus behavioral effects and, thus, risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, with only volatility related to idiosyncratic risk. We i...

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Published in:	Journal of financial economics Vol. 135; no. 3; pp. 629 - 652
Main Authors:	Asness, Cliff, Frazzini, Andrea, Gormsen, Niels Joachim, Pedersen, Lasse Heje
Format:	Journal Article
Language:	English
Published:	Amsterdam Elsevier B.V 01.03.2020 Elsevier Sequoia S.A
Subjects:	Asset pricing Behavioral economics Constraints Correlation analysis Economic models Financial economics Gambling Leverage Leverage constraints Lottery demand Margin Risk Risk behavior Risk factors Sentiment Theory Theory of constraints Lottery demand Leverage constraints G02 G12 G15 G14 Asset pricing Sentiment Margin
ISSN:	0304-405X, 1879-2774
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Abstract	We test whether the low-risk effect is driven by leverage constraints and, thus, risk should be measured using beta versus behavioral effects and, thus, risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, with only volatility related to idiosyncratic risk. We introduce a new betting against correlation (BAC) factor that is particularly suited to differentiate between leverage constraints and behavioral explanations. BAC produces strong performance in the US and internationally, supporting leverage constraint theories. Similarly, we construct the new factor SMAX to isolate lottery demand, which also produces positive returns. Consistent with both leverage and lottery theories contributing to the low-risk effect, we find that BAC is related to margin debt while idiosyncratic risk factors are related to sentiment.
AbstractList	We test whether the low-risk effect is driven by leverage constraints and, thus, risk should be measured using beta versus behavioral effects and, thus, risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, with only volatility related to idiosyncratic risk. We introduce a new betting against correlation (BAC) factor that is particularly suited to differentiate between leverage constraints and behavioral explanations. BAC produces strong performance in the US and internationally, supporting leverage constraint theories. Similarly, we construct the new factor SMAX to isolate lottery demand, which also produces positive returns. Consistent with both leverage and lottery theories contributing to the low-risk effect, we find that BAC is related to margin debt while idiosyncratic risk factors are related to sentiment.
Author	Pedersen, Lasse Heje Asness, Cliff Frazzini, Andrea Gormsen, Niels Joachim
Author_xml	– sequence: 1 givenname: Cliff surname: Asness fullname: Asness, Cliff organization: AQR Capital Management, LLC, Two Greenwich Plaza, Greenwich, CT 06830, USA – sequence: 2 givenname: Andrea surname: Frazzini fullname: Frazzini, Andrea organization: AQR Capital Management, LLC, Two Greenwich Plaza, Greenwich, CT 06830, USA – sequence: 3 givenname: Niels Joachim surname: Gormsen fullname: Gormsen, Niels Joachim email: niels.gormsen@chicagobooth.edu organization: University of Chicago, Booth School of Business, 5807 South Woodlawn Avenue, Chicago, IL 60637, USA – sequence: 4 givenname: Lasse Heje surname: Pedersen fullname: Pedersen, Lasse Heje organization: AQR Capital Management, LLC, Two Greenwich Plaza, Greenwich, CT 06830, USA
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Snippet	We test whether the low-risk effect is driven by leverage constraints and, thus, risk should be measured using beta versus behavioral effects and, thus, risk...
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SubjectTerms	Asset pricing Behavioral economics Constraints Correlation analysis Economic models Financial economics Gambling Leverage Leverage constraints Lottery demand Margin Risk Risk behavior Risk factors Sentiment Theory Theory of constraints
Title	Betting against correlation: Testing theories of the low-risk effect
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