Betting against sentiment? Seemingly unrelated anomalies and the low‐risk effect

The negative CAPM alphas of high‐beta and high‐variance stocks are attributable to an unaccounted factor in the CAPM. We use eight seemingly unrelated anomalies to construct a composite factor in the spirit of the optimal orthogonal portfolio (FOP). Accounting for FOP re‐establishes a positive relation between beta and average returns in time series regressions as well as cross‐sectional and explains the negative alphas of high‐beta and high‐variance stocks. To analyze economic drivers behind FOP, we perform a horse race between leverage constraints, investor sentiment, and disagreement. Our results highlight investor sentiment as the most promising explanation for the low‐risk effect.