Testing whether Leverage Constraints Explain the Low Beta Anomaly

Abstract

One of the longstanding puzzles in financial economics is understanding why the average payoff on an investment is unrelated to the risk relative to the market. The leading explanation points to leverage constrained investors who, unable to obtain higher returns by leveraging low risk assets, turn to riskier assets which promise larger returns. However, risky assets often under-perform, and on average investors are not compensated for taking on the extra risk. This effect is known as the Low Beta Anomaly, where beta measures risk relative to the market. Interestingly, leverage constrained investors might be at fault for the low returns - over investing in risky assets increases their current prices, and lowers future returns. This paper examines if the theory of leverage constraints is consistent with the flatness of the security market line(i.e. relation between average returns and betas) by analyzing the distribution of portfolio beta for various types of investors having borrowing constraints imposed through regulation (e.g: mutual fund, insurance companies, banks, etc.). We estimate what fraction of the market is leverage constrained and test if the observed level of borrowing restrictions can account for the Low Beta Anomaly using the model of Frazzini and Pedersen, 2013 Our results show that the slope of the security market line is only explained by the fraction of constrained investors if the unconstrained investors are much more reluctant to take on risk than previously thought.