What Drives the Trend and Behavior in Aggregate (Idiosyncratic) Variance? Follow the Bid-Ask Bounce

We theoretically establish a market microstructure bias embedded in the estimate of industry-adjusted idiosyncratic variance and empirically show that the bid-ask spread eliminates the observed time trend in aggregate idiosyncratic variance (Campbell, Lettau, Malkiel, and Xu, 2001). These results are robust across various risk-based measures of idiosyncratic variance and through time. Two natural experiments illustrate that an exogenous shock to the bid-ask spread is associated with a subsequent decline in the aggregate idiosyncratic variance. The microstructure hypothesis dominates any of the alternative explanations, including profitability, earnings shocks, growth options, or retail trading for the trend in idiosyncratic variance