Betting against noisy beta

Abstract

Strategies that overweight low beta stocks and underweight high beta stocks earn positive alphas. Price noise is known to affect high beta stocks, hence, noise trading can be expected to significantly affect the performance of these strategies. I study the impact of flows between bond and equity funds (net exchanges) on the Frazzini and Pedersen’s (2014) Betting Against Beta (BAB) factor in the US for a period 1984 until 2015. I find mispricing and reversal effects. In particular, when retail investors are caught up in the market euphoria, they are too optimistic, and shift their holdings from bond to equity mutual funds. My results suggest that higher-than-rational beta stocks are particularly exposed to this non-fundamental price pressure. Subsequently, the short-term reversal relation is stronger for high beta stocks and, therefore, returns are significantly lower. As a results, while the market performs poorly, the BAB factor returns are significantly positive. A dynamic trading strategy that is based on signals from past net exchanges and the BAB factor significantly outperforms the market factor by 0.71% monthly on average, during months following positive net exchanges by 1.62% and during market stress episodes by 2.14%. Accounting for transaction costs, other equity risk factors and non-standard procedures used in the BAB construction reduces the profitability of the strategy, but does not change the conclusions. My findings suggest that a major part of the success of the BAB factor is due to its exposure to flow-induced price noise.