Arguably the most remarkable anomaly in finance is the violation of therisk‐return tradeoff within the stock market: Over the past 40 years,high volatility and high beta stocks in U.S. markets have substantiallyunderperformed low volatility and low beta stocks. We propose anexplanation that combines the average investor's preference for risk andthe typical institutional investor's mandate to maximize the ratio ofexcess returns to tracking error relative to a fixed benchmark (theinformation ratio) rather than the Sharpe ratio. Models of delegatedasset management show that such mandates discourage arbitrage activityin both high alpha, low beta stocks and low alpha, high beta stocks.This explanation is consistent with several aspects of the lowvolatility anomaly including why it has only strengthened even asinstitutional investors have become more numerous.
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