Abstract

We present a model with leverage and margin constraints that vary across investors and time. We find evidence consistent with each of the model’s five central predictions: (1) Because constrained investors bid up high-beta assets, high beta is associated with low alpha, as we find empirically for US equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures. (2) A betting against beta (BAB) factor, which is long leveraged low-beta assets and short high-beta assets, produces significant positive risk-adjusted returns. (3) When funding constraints tighten, the return of the BAB factor is low. (4) Increased funding liquidity risk compresses betas toward one. (5) More constrained investors hold riskier assets.

Scientific Portfolio AI- Generated Summary

This paper presents a model that explores leverage and margin constraints that vary across investors and time. The authors find evidence consistent with their model’s predictions, including the association of high beta with low alpha and the positive risk-adjusted returns of a betting-against-beta factor.

The authors begin by introducing the concept of betting against beta (BAB), which involves taking long positions in low-beta assets and short positions in high-beta assets. They argue that this strategy generates positive risk-adjusted returns because high-beta assets are overpriced due to the leverage constraints faced by many investors. The authors then present a model that incorporates these constraints and shows how they can lead to the observed patterns in asset prices and returns.

The model assumes an overlapping-generations economy in which agents are born each period with wealth and live for two periods. Agents trade securities, which pay dividends and have shares outstanding. The authors show that the equilibrium prices and returns of securities depend on the distribution of investors’ leverage and margin constraints. In particular, high-beta assets are overpriced because they are held by investors who face binding leverage constraints.

The authors then test their model’s predictions using data on U.S. and international equities. They find that high-beta assets have low alpha, consistent with the model’s prediction that they are overpriced. They also find that a betting-against-beta factor generates positive risk-adjusted returns, consistent with the model’s prediction that high-beta assets are overpriced. The authors argue that these results provide strong support for their model’s assumptions and predictions.

The authors conclude by discussing the implications of their model for investors and policymakers. They argue that investors can profit from the BAB strategy by taking long positions in low-beta assets and short positions in high-beta assets. They also argue that policymakers should be aware of the potential for leverage constraints to distort asset prices and returns. Overall, the paper provides a novel and compelling explanation for the observed patterns in asset prices and returns and has important implications for both investors and policymakers.