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
“Betting against beta”, by Andrea Frazzini , Lasse Heje Pedersen, AQR Capital Management, April 2013
“We present a model with leverage and margin constraints that vary across investors and time. We find evidence consistent with each of the model’s five central predictions: (1) Because constrained investors bid up high-beta assets, high beta is associated with low alpha, as we find empirically for US equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures. (2) A betting against beta (BAB) factor, which is long leveraged low-beta assets and short high-beta assets, produces significant positive riskadjusted returns. (3) When funding constraints tighten, the return of the BAB factor is low. (4) Increased funding liquidity risk compresses betas toward one. (5) More constrained investors hold riskier assets.”
Buffett’s Alpha. by Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen
The authors find that Buffet has been picking low volatility, low beta stocks with consistent earnings, and then levering up his investment using his insurance float.
“Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks. Decomposing Berkshires’ portfolio into ownership in publicly traded stocks versus wholly-owned private companies, we find that the former performs the best, suggesting that Buffett’s returns are more due to stock selection than to his effect on management.”
Link to paper Slide version