Do limits to arbitrage explain the benefits of volatility-managed portfolios?

We investigate whether transaction costs, arbitrage risk, and short-sale constraints explain the abnormal returns of volatility-managed equity portfolios. Even using five cost-mitigation strategies, after accounting for transaction costs, volatility management of common asset-pricing factors besides the market return generally produces zero abnormal returns and significantly reduces Sharpe ratios. In contrast, abnormal returns of the volatility-managed market portfolio are profitable after transaction costs and concentrated in the most easily arbitraged stocks, those with low arbitrage risk and short-sale constraints. Moreover, the managed-market strategy only provides superior performance when sentiment is high, consistent with prior theory that sentiment traders under-react to volatility.