Common explanations of the low volatility anomaly involve biases or frictions that cause investors to overpay for high volatility assets, giving them a negative alpha within the CAPM model, yet currently all such mechanisms are either heuristic or partial equilibrium. This paper shows that leverage constraints of Frazzini and Pedersen (2014) alone cannot explain this result if there also exist rational investors. If 3 non-standard assumptions are added — hybrid relative utility, delusional subset of investors, residual systematic risk across beta — then we can capture several facts existing models cannot simultaneously capture: a positive return to the market, positive holdings by rational investors to negative CAPM-alpha stocks, and a negative Security Market Line. New data relevant to these assumptions are presented.

Keywords: volatility effect, anomaly, CAPM, arbitrage, asset pricing, agency effects, behavioral finance, low volatility anomaly

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