A strategic beta-arbitrage strategy, first suggested by Black (1993), builds into the portfolio a
systematic tilt towards low-beta stocks and away from high-beta stocks. This tilt is held constant
irrespective of the market environment. For example, holding a $1 long position in low-beta stocks
(assumed beta 0.5) and holding a $0.33 short position in high-beta stocks (assumed beta 1.5) will
result in a strategic, market-neutral beta-arbitrage portfolio. If the realized return over the risk-free
rate for high-beta stocks is lower than three times the return on the low-beta stocks, then this beta-
arbitrage strategy makes a profit. Conversely, if the realized return over the risk-free rate for high-
beta stocks is higher than three times the return on the low-beta stocks, then this beta-arbitrage
strategy makes a loss.
What creates the persistent beta-arbitrage opportunity, or equivalently, the persistent overpricing of
high-beta stocks relative to low-beta stocks that strategic beta-arbitrage seeks to exploit? First, and
perhaps the most obvious explanation, originally suggested by Black, Jensen, and Scholes (1972) and
Black (1973), is that some investors want to hold a high-risk high-return portfolio, yet are reluctant to
take leverage. This demand for risky, high-beta stocks pushes up their valuations.
Second, Karceski (2002) suggests the following agency-based explanation for the absence of cross-
sectional beta premium, which related to above-mentioned borrowing constraints. Traditional long-
only managers who manage retail mutual funds prefer high-beta and dislike low-beta stocks for the
following reason. The majority of new inflows to mutual funds take place in bull markets.
Furthermore, the inflows go to the funds with the best recent absolute performance (irrespective of the
portfolio’s beta). Asymmetrically, money in mutual funds is very sticky, and bad performance does not
typically result in significant outflows. This set of incentives makes it imperative for the mutual fund
managers to perform well in up markets. The only generally available way to systematically do so
without leverage is to buy high-beta stocks.
Third, it is possible that irrational trader activity causes both overvaluation and high beta. For
example, suppose that irrational investor sentiment affects the market as a whole. Suppose further
that irrational investors are face constraints or are otherwise reluctant to short, and thus only hold long
positions. In such situation, stocks that are held by irrational investors simultaneously exhibit
overvaluation and excessive comovement with the market.
Is the market-neutral beta-arbitrage strategy simply a value strategy in disguise, especially given that
during the recent years value (i.e., low P/B) stocks have had lower betas than growth (i.e., high P/B)
stocks? The answer to this question, given by Daniel and Titman (1997) and Davis, Fama, and French
(2000), is that the market-neutral beta-arbitrage strategy is not simply a repackaged version of the
long-value-short-growth strategy. Even if one forces the market-neutral beta-arbitrage strategy to be
neutral with respect to the price-to-book characteristics, the historical premium on the strategy is
positive as the below Figure 2 shows: