The capital asset pricing model has suffered a few indignities of late. The most recent comes from a series of academic articles questioning whether beta—or the one moving part of the model that determines the expected return of risky assets—is doing a good job of predicting subsequent returns. These studies find that high-beta stocks don’t perform as well as they should, and that low-beta stocks do better than the model would predict. In other words, the slope of the security market line, or the tradeoff between risk and return, isn’t a straight line.
This is a problem for efficient-market types because it suggests that high-beta securities are overpriced and low-beta securities are too cheap. If cheap and expensive securities exist within a free and open market, there should be an opportunity for sophisticated investors to earn riskless profits by selling expensive securities to buy the cheap ones.
It’s tempting to conclude that CAPM and beta may be of limited use if the data don’t match the theoretical relationship between risk and return according to the model. However, Andrea Frazzini and Cliff Asness of AQR Capital Management and Harrison Hong and David Sraer of Princeton University believe that the problem is not with the theory, but with the limitations of capital markets. These limitations explain why high-beta stocks become overpriced and why their prices don’t fall, even when sophisticated investors are aware that a mispricing exists.
In an article just published in the Financial Analysts Journal, Frazzini, Asness and Lasse Pedersen of New York University attribute the beta anomaly to investors’ unwillingness to leverage their investment portfolios. Assets may be seen as existing on a continuum of risk based on covariance with the market for risky assets (beta). The market portfolio, which according to the authors consists of 42% stocks, 48% bonds and a few other assets, provides a beta of one.
According to modern portfolio theory, this value-weighted market portfolio provides the highest return per unit of investment risk, or Sharpe ratio. Except it doesn’t.
Bonds consistently have higher Sharpe ratios than stocks. This fact isn’t of much use to most investment advisors because their clients want a higher expected return than they can get from bonds alone. So an advisor selects a portfolio that consists of a mix of stocks and bonds that provides a higher expected return with more risk. But the authors point out that you don’t have to increase your stock allocation to get a higher expected return. You can just borrow money and invest more in bonds. As you increase your leverage, your risk goes up but so does your expected return.
Theoretically, you can create a portfolio of bonds that has the same risk as a balanced equity/bond portfolio through leverage. The problem is that many investors can’t easily create a leveraged portfolio.
This “leverage aversion” increases demand for riskier assets among investors who are willing to accept greater risk for greater return but are not willing or able to do so through a leveraged portfolio. Mutual funds and pension managers may also be restricted from increasing leverage to generate greater returns. So investors demand more risky assets, which drive down their risk-adjusted performance. Safer assets become less popular, resulting in a higher Sharpe ratio. Aversion to leverage or institutional barriers to creating leveraged portfolios among investors creates the price pressures that allow less risky investments to outperform in an otherwise efficient market.
Frazzini and his co-authors provide convincing evidence that the outperformance of low-beta investments isn’t just the result of mining data from a brief period of U.S. asset returns. Between 1926 and 2010, stocks had a Sharpe ratio of 0.35 while bonds achieved a much higher 0.47. A portfolio that maximized Sharpe ratio consisted of 88% bonds and 12% stocks—much more heavily weighted toward bonds than the theoretically optimal value-weighted market portfolio from modern portfolio theory.
While stocks indeed outperform bonds historically by beating the risk-free rate by 6.71% versus 1.56% for bonds, the authors remind us that this is theoretically irrelevant. They insist that an investor focus not on asset allocation but on risk parity; that it to say, compare portfolios that have the same amount of risk in order to judge their performance. By leveraging the most efficient 88% bond portfolio to match the risk of a traditional 60/40 portfolio, it was possible to achieve an annual return that is 3.34% higher.
Thus, one could create a portfolio that is as risky as a 60/40 portfolio by using a leveraged portfolio heavily weighted toward bonds and achieve a 334 basis point performance improvement. This surprisingly robust performance by a leveraged low-risk portfolio also outpaced a sample of global markets and within different time periods.
Leverage aversion is one explanation for the underperformance of high-beta securities. Hong and Sraer present a convincing argument that market sentiment, or the time-varying whims of investors who become emotionally attached to certain investments, leads to high prices for speculative stocks that more sophisticated investors are powerless to correct. Impulsive investors become enamored of stocks whose value may be very high—for example an Internet company that sells pet food using an amusing sock as a company spokespuppet—and are willing to pay high prices for the shares.
Sophisticated investors may try to short sell the stock if the price increases beyond fundamental value. But their ability to do so is limited by well-known short sale constraints, most notably limits on short sales by institutions like mutual funds and the possibility of going broke waiting for the price to correct while option contracts expire. With a limited number of stock shares, the price gets set by the most optimistic investors while the pessimists are left on the sidelines.
Hong and Sraer look at stocks for which there is a lot of disagreement among analysts about expected earnings. When there is a broad range of estimated earnings for a firm, subsequent excess returns actually decline with beta. This implies that uncertainty about earnings leads to high prices and poor returns for higher beta equities. The authors find that this relationship doesn’t exist among higher beta stocks where there is little analyst disagreement about expected earnings.
However, disagreement is much more common among higher beta stocks. Higher beta stocks suffer more when the fortunes of the company are more speculative, and the authors find that many higher beta stocks have uncertain future prospects. Think of speculative earnings as a cancer that infects many high-beta stocks as a result of overoptimistic investors and short sale constraints.
To an advisor who isn’t willing or practically able to recommend a leveraged portfolio, an easy solution is to forget about focusing on the allocation of stocks and bonds within an investment portfolio and instead focus on the risk of the portfolio. In an unpublished paper co-authored with Texas Tech University doctoral student Shaun Pfeiffer, I find that a portfolio constructed of equity mutual funds within the lowest beta decile (bottom 10%) allows an investor to achieve a higher risk-adjusted performance than a traditional 60/40 portfolio consisting of S&P 500 funds and bonds if they are willing to increase total equity allocation.
A portfolio consisting of 82% low-beta mutual funds and 18% low-risk bonds has the same standard deviation as a portfolio with 37% high-beta mutual funds and 63% bonds. However, because the low-beta funds have a higher Sharpe ratio (0.73 versus 0.56) than the high-beta funds, the mean total portfolio return much higher at the same level of risk. Between January 1994 and January 2012, the annual return of a low-beta portfolio at risk parity with a high-beta portfolio outperformed by 160 basis points (6.86% for low-beta versus 5.26% for high-beta).
Taking advantage of lower-risk investments means either increasing one’s equity exposure within a portfolio or increasing portfolio leverage in order to align portfolio risk with a client’s risk tolerance. Both of these can be difficult. In the example above, a low-beta equity strategy requires more than an 80% equity allocation in order to provide the same risk as a traditional 60/40 portfolio. Is it possible to defend such a high equity allocation as suitable for an average client? Although technically appropriate, it flies in the face of a long-held paradigm among investors. In order to take advantage of low-beta investing strategies, it may be necessary to move beyond seeing a portfolio as a percentage of stocks and bonds.
Are there ways to practically increase portfolio leverage? One easy and inexpensive way to increase leverage is by borrowing against home equity by refinancing a mortgage and investing the proceeds in a high Sharpe ratio asset portfolio. Home equity is a relatively inexpensive source of long-run leverage that avoids some of the pitfalls of margin investing as well as being a tax-advantaged form of borrowing.
Like value and small-cap investing, evidence is mounting that a low-beta strategy provides a potential source of alpha for investors. While CAPM may not officially be dead, its cracks provide an opportunity for investors to gain an edge.
Michael Finke is a professor and coordinator of the doctoral program in personal financial planning at Texas Tech University.