Betting Against (Bad) Beta

ArXiv ID: 2409.00416 “View on arXiv”

Authors: Unknown

Abstract

Frazzini and Pedersen (2014) Betting Against Beta (BAB) factor is based on the idea that high beta assets trade at a premium and low beta assets trade at a discount due to investor funding constraints. However, as argued by Campbell and Vuolteenaho (2004), beta comes in “good” and “bad” varieties. While gaining exposure to low-beta, BAB factors fail to recognize that such a portfolio may tilt towards bad-beta. We propose a Betting Against Bad Beta factor, built by double-sorting on beta and bad-beta and find that it improves the overall performance of BAB strategies though its success relies on proper transaction cost mitigation.

Keywords: Betting against beta, Factor investing, Bad beta, Asset pricing, Portfolio construction

Complexity vs Empirical Score

• Math Complexity: 8.5/10
• Empirical Rigor: 7.0/10
• Quadrant: Holy Grail
• Why: The paper involves advanced theoretical finance math (ICAPM, VAR decompositions, precise beta definitions) but is heavily grounded in empirical backtesting with CRSP data, transaction cost analysis, and replication of existing factors, showing a blend of theoretical and practical rigor.

  flowchart TD
    subgraph A["Research Goal"]
        G1["Does ignoring 'bad beta'<br>limit Betting Against Beta<br>performance?"]
    end

    subgraph B["Key Methodology"]
        M1["Database: CRSP & Compustat<br>Data: US Stocks, 1963-2013"]
        M2["Double Sort Strategy<br>1. Sort by Market Beta<br>2. Sort by Bad Beta (Covariance with<br>bad macro states)"]
    end

    subgraph C["Computational Process"]
        C1["Reconstruct Standard BAB<br>(Frazzini & Pedersen 2014)"]
        C2["Construct BABB: Betting Against<br>Bad Beta Factor<br>(Long Low Bad-Beta / Short High Bad-Beta)"]
    end

    subgraph D["Key Findings & Outcomes"]
        F1["Performance:<br>BABB generates higher risk-adjusted<br>returns than standard BAB"]
        F2["Limitation:<br>Success depends on strict<br>transaction cost mitigation"]
        F3["Conclusion:<br>Controlling for Bad Beta improves<br>BAB strategies"]
    end

    A --> B
    B --> C
    C --> D