We investigate whether transaction costs, arbitrage risk, and short-sale impediments explain the abnormal returns of volatility-managed equity portfolios. Even using six cost-mitigation strategies, after transaction costs, volatility management of 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 robust to transaction costs and concentrated in the most easily arbitraged stocks, those with low arbitrage risk and impediments to short selling. Moreover, the managed market strategy only provides superior performance when sentiment is high, consistent with prior theory that sentiment traders underreact to volatility.

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.