A few weeks ago, we covered the Frazzini-Pedersen paper describing how low-beta stocks outperform those with high beta. They theorized that this was because many investors (i.e., most large funds) tend to be constrained against making levered bets, and therefore compensate for this limitations by crowding into high-beta stocks. This in turn lowered the future return of those stocks.
But something didn’t seem to make sense about this explanation to me. If high-beta stocks were being chased by investors, would this not drive the price up even more?
A paper that I recently came across poses a possible resolution to this question. In “Leverage as a Weapon of Mass Shareholder-Value Destruction; Another Look at the Low Beta Anomaly” author Andricopoulos suggests that the pool of high beta stocks are mixed in with companies that lever up (i.e,, have high debt to equity ratios) as a way to disguise their underperformance. Measures such as ROE and P/E can be made to look attractive with changes in capital structure. Over time, rather than correcting their core challenges, these management teams become accustomed to using leverage, and also become risk-averse since they must meet their debt obligations. Risk aversion leads to long-term under-investment in new products, which in turn causes them to underperform.
“Leverage as a Weapon of Mass Shareholder-Value Destruction; Another Look at the Low Beta Anomaly”, Ari D. Andricopoulos. Dacharan Advisory, November 2016