The Booms and Busts of Beta Arbitrage

Abstract

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 generates booms and busts in the strategy’s abnormal trading profits. In times of low arbitrage activity, the beta-arbitrage strategy exhibits delayed correction, taking up to three years for abnormal returns to be realized. In contrast, when arbitrage activity is high, prices overshoot and then revert in the long run. We document a novel positive-feedback channel operating through firm leverage that facilitates these boom-and-bust cycles. This paper was accepted by Lukas Schmid, finance. Funding: This work is financially supported by National Natural Science Foundation of China [NSFC Grant Number 72303226] and the Key Program of National Natural Science Foundation of China [NSFC Grant Number 72233003]. Supplemental Material: The internet appendix and data are available at https://doi.org/10.1287/mnsc.2023.4929 .