Betting Against Beta or Demand for Lottery?

Betting Against Beta or Demand for Lottery?

June 9, 2014 Research Insights, Low Volatility Investing
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(Last Updated On: January 18, 2017)

Betting Against Beta or Demand for Lottery

Abstract:

Frazzini and Pedersen (2014) document that a betting against beta strategy that takes long (short) positions in low (high) beta stocks generates large abnormal returns of 6.6% per year, and attribute this phenomenon to funding liquidity risk. We investigate alternative explanations for this effect, and find that it is caused by demand for lottery-like assets, a behavioral phenomenon. Requiring betting against beta portfolios to be neutral to lottery demand eliminates the abnormal returns. Controlling for lottery-demand, multivariate analyses detect a theoretically consistent positive relation between beta and returns. Factor models that include our lottery-demand factor explain the abnormal returns of betting against beta portfolios. We conclude that the betting against beta phenomenon is driven by demand for lottery-like stocks.

Alpha Highlight:

This paper documents that the betting against beta (BAB) strategy is mainly driven by investors demand for lottery-like stocks. The authors use the MAX measure, defined as the average of the highest five daily stock returns over the past month, to proxy for the lottery-demand of a stock. Figure 1 shows a heat map of the stocks that fall into portfolios measured by Beta and the MAX (lottery demand) measures:

beta and lottery
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The above picture documents that high beta stocks also have a high lottery demand, while low beta stocks also have a low lottery demand.   The authors then construct a measure, labeled FMAX, as a lottery-demand factor. The results are informative:

beta and lottery 2
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Once the authors control for the lottery-demand (FMAX factor), the alpha for the BAB strategy becomes insignificant!

Do you think lottery bias explains the BAB factor?

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About the Author

Jack Vogel, Ph.D.

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.


  • Andrew M.

    My understanding was that leverage aversion was the driver of the BAB factor as the BAB factor also exists across asset classes (fixed income, commodities and currencies) and also explains the existence of leveraged ETFs.

  • That is one version of the story backed by evidence. These authors tell an alternative story, backed by evidence. The truth probably lies somewhere in between, and/or both elements drive the effect.