- 1Leverage constraints force investors to buy risky assets, making them overpriced
- 2Low-beta stocks are underpriced and outperform high-beta stocks across 20+ asset classes
- 3The "Betting Against Beta" (BAB) factor earns significant risk-adjusted returns globally
- 4The effect works in stocks, bonds, currencies, commodities, and credit markets
- 5This provides the theoretical foundation for the low-volatility anomaly
#The Paper at a Glance
Title: Betting against beta
Authors: Andrea Frazzini and Lasse Heje Pedersen (AQR Capital Management)
Published: Journal of Financial Economics, 2014
DOI: 10.1016/j.jfineco.2013.10.005
While Ang et al. (2006) documented the volatility anomaly, Frazzini and Pedersen explained it. Their theory is elegant: investors who can't use leverage are forced to buy risky assets to boost returns, making those assets overpriced.
#The Core Theory
The Leverage Constraint
Imagine two investors trying to achieve a 10% expected return:
Unconstrained Investor: - Can use leverage - Buys low-risk assets (6% return) with 2x leverage → 12% expected return - Lower volatility per unit of return
Constrained Investor (most people): - Cannot use leverage (regulatory limits, margin requirements, personal preference) - Must buy high-risk assets to reach 10% - Higher volatility, worse risk-adjusted returns
Most investors face leverage constraints: - Pension funds have regulatory limits - Mutual funds have SEC restrictions - Retail investors dislike margin - Even hedge funds face borrowing costs
The Demand Imbalance
Since most investors are constrained, they create excess demand for high-beta assets:
| Asset Type | Demand | Price Impact | Expected Return |
|---|---|---|---|
| High Beta | Too much demand | Prices pushed up | Returns pushed down |
| Low Beta | Too little demand | Prices stay fair | Returns stay higher |
#Evidence Across Asset Classes
The BAB factor isn't just a stock market phenomenon. Frazzini and Pedersen tested it across:
| Asset Class | BAB Annual Return | t-statistic |
|---|---|---|
| U.S. Equities | 8.6% | 4.5 |
| International Equities | 7.3% | 4.1 |
| Government Bonds | 3.2% | 2.8 |
| Credit (Corporate Bonds) | 4.1% | 3.0 |
| Currencies | 3.8% | 2.5 |
| Commodities | 3.5% | 2.2 |
| Average Across All | 5.1% | 3.2 |
The consistency across fundamentally different asset classes is remarkable. It's extremely unlikely that the same pattern would appear in stocks, bonds, currencies, AND commodities by chance.
#How BAB Works in Practice
Portfolio Construction
- 1Rank all stocks by beta (sensitivity to market movements)
- 2Go long low-beta stocks (leverage them up to beta = 1)
- 3Go short high-beta stocks (de-lever them to beta = 1)
- 4The resulting portfolio has zero market exposure but positive expected returns
The Result
A portfolio with no market risk that earns roughly 8% per year. This shouldn't exist under the CAPM—but it does, because the theory's assumption of unlimited leverage is wrong.
#Why BAB Persists
1. Constraints Don't Change
Leverage constraints are structural—they come from regulations, fund charters, and human psychology. They're not going away.
2. Career Risk
A fund manager who holds boring, low-beta stocks will underperform during bull markets. This creates career risk that prevents many professionals from exploiting the anomaly.
3. Tracking Error
Institutional investors are evaluated relative to benchmarks. Low-beta portfolios have significant tracking error, making them uncomfortable even when they deliver better risk-adjusted returns.
#Critical Perspectives
Not everyone accepts BAB at face value:
- Novy-Marx & Velikov (2022) critiqued the portfolio construction methodology and showed that BAB returns are sensitive to how you handle small, illiquid stocks
- However, even critics confirm the direction of the effect: low-beta stocks outperform high-beta stocks on a risk-adjusted basis
The debate is about the magnitude, not the existence, of the anomaly.
#How This Applies to Our Rankings
Our low volatility factor (10% weight) captures the essence of BAB. While we use realized volatility rather than beta, the core insight is identical: calm stocks are underpriced, volatile stocks are overpriced.
The 10% weight reflects that low volatility is primarily a risk-reduction factor rather than a return-maximizing one. Combined with profitability (30%) and momentum (25%), it creates a portfolio that delivers strong returns with smoother ride quality.
See lowest-volatility stocks →
#Academic Source
Frazzini, A., & Pedersen, L. H. (2014). "Betting against beta." Journal of Financial Economics, 111(1), 1-25.
Last updated: February 1, 2026