Institutional Investors

The Opportunities And Risks In Low-Beta Strategies

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This article originally appeared on ETF.COM here.

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A 2014 study by Andrea Frazzini and Lasse Heje Pedersen, “Betting Against Beta,” established strong support for low-beta strategies. The authors found that, for U.S. stocks, the betting against beta (BAB) factor realized a Sharpe ratio of 0.78 between 1926 and March 2012. That was about twice the value effect’s Sharpe ratio and 40% higher than momentum’s Sharpe ratio during the same period. (The BAB factor is a portfolio that holds low-beta assets leveraged to a beta of 1 and shorts high-beta assets de-leveraged to a beta of 1.)

In addition, Frazzini and Pedersen found that the BAB factor showed highly significant risk-adjusted returns after accounting for its realized exposure to the market beta, value, size, momentum and liquidity factors. In fact, BAB realized a significant positive return in each of the four 20-year subperiods between 1926 and 2012. What’s more, their analysis of 19 international equity markets revealed similar results.

The authors further found that BAB returns have been consistent across countries, across time, within deciles sorted by size, and within deciles sorted by idiosyncratic risk, as well as consistently robust to a number of specifications. These consistent results suggest coincidence or data mining are unlikely explanations.

Alpha, beta and Sharpe ratios

As still more supporting evidence, Frazzini and Pedersen found that in each asset class they examined (stocks, U.S. Treasury bonds, credit markets, and futures markets for currencies and commodities), alphas and Sharpe ratios declined almost monotonically as beta increased.

They concluded: “This finding provides broad evidence that the relative flatness of the security market line is not isolated to the U.S. stock market but that it is a pervasive global phenomenon. Hence, this pattern of required returns is likely driven by a common economic cause.”

The intuition behind the anomaly is that leverage-constrained investors who, instead of applying leverage, obtain an expected return higher than the market’s expected return through overweighting high-beta stocks and underweighting low-beta stocks in their portfolios. Their actions lower future risk-adjusted returns on high-beta stocks and increase future risk-adjusted returns on low-beta stocks.

Evidence for low-beta and low-volatility strategies extends to international equities as well. In the 2007 article “The Volatility Effect,” David Blitz and Pim van Vliet found that low volatility works globally for developed market large-cap stocks, with an annual spread between the lowest-volatility and highest-volatility stocks of 5.9% from 1986 through 2006. The lowest-risk decile had a Sharpe ratio of 0.72, compared with Sharpe ratios of 0.40 for the market and 0.05 for the highest-volatility decile. Results also held for the U.S., European and Japanese markets.

In the 2013 study, “The Volatility Effect in Emerging Markets,” Blitz, Juan Pang and van Vliet extended these results to emerging markets. Using data from 30 emerging market countries covering the period 1988 through 2010, they found an annual spread between low-volatility and high-volatility stocks of 2.1%. Interestingly, returns increased with volatility until the highest-volatility quintile, whose returns lagged the rest.

Time-varying premium

Esben Hedegaard of AQR Capital Management contributes to the literature on the low-beta anomaly with his June 2018 study, “Time-Varying Leverage Demand and Predictability of Betting-Against-Beta.”

He demonstrates that the returns to BAB are time-varying and dependent on prior-period returns. For the U.S., his dataset covers the period 1931 through January 2018. His international data set, covering 23 countries, begins in 1988 or later.

Read the full article by Larry Swedroe, Advisor Perspectives

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