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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.
Following is a summary of his key findings:
- High (low) past returns on the market forecast high (low) future returns on the BAB factor; realized BAB returns are higher (lower) following high (low) past market returns.
- Because expected returns move opposite to prices, high (low) market returns lead to contemporaneously low (high) returns on the BAB factor.
- The results held for both U.S. BAB returns and all 23 international country BAB returns, as well as for BAB factors formed from country indexes.
- The economic magnitude is large, with a coefficient of 0.41 on the past 12-month average BAB return. A 10% return over the past 12 months predicts an abnormal 4% annualized return on the BAB factor over the next month.
- The difference in BAB returns following high and low market returns is not explained by different exposures to the common factors of size, value or momentum.
- A BAB-timing strategy that takes a position across all 24 countries (based on past 12-month returns) generated positive alpha to a two-factor (size and value) model with the market and BAB factors in all but two of them, and the alpha was significant in 12 of the 24 countries.
- Sorting countries based on their past market returns shows that future BAB returns are higher (lower) in countries for which past market returns were higher (lower) than the cross-country average market return.
Hedegaard also tested the predictability of BAB using country indexes. The BAB strategy goes long the country indexes with a low beta relative to a global index and short the country indexes with a high beta relative to a global index. He found both that the BAB strategy generates positive returns in a region of 25 emerging market countries and that, for each region, the returns on the BAB strategy are predictable by past returns on a cap-weighted index of the countries in it.
Hedegaard concluded: “These results show a strong pattern in the time-series and cross-country variation of expected returns. Low-beta stocks outperform high-beta stocks on average, on a risk-adjusted basis, but the outperformance is stronger when and where past market returns are high.”
His findings have important implications for investors, in particular that, when past returns are high, the risks of owning high-beta stocks significantly increase. Mutual fund investors should be sure they understand their fund’s level of exposure to market beta after periods of strong performance.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
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