The volatility puzzle of the beta anomaly

This paper shows that leading theories of the beta anomaly fail to explain the anomaly's conditional performance. Abnormal returns and Sharpe ratios of betting-against-beta (BAB) factors rise following months with below-median realized volatility, even controlling for mispricing, limits to arbitrage, lottery preferences, analyst disagreement, and sentiment. Moreover, the leverage constraints theory counterfactually predicts that market and BAB Sharpe ratios increase with volatility. We further show that institutional investors shift their demand from high- to low-beta stocks as volatility increases, and the resulting price impact is sufficient to explain the difference in abnormal BAB returns between high- and low-volatility states.