Would you give money to a manager who said their strategy was to buy dull stocks? You probably should; but the conundrum here is that no manager will advertise such a strategy as they’ll raise little money if they do. There is now however clear and growing proof that it’s a very sound course of action,
A debate has been ongoing for some time now on the so called ‘Beta-Anomaly’ that’s been observed in many asset classes apart from just traded equities; it extends also to bonds, credits and futures.
What is the ‘Beta-Anomaly’? Since the crunching of big data sets at speed became possible in the 1970s analysts have been surprised to find the counter-intuitive result when looking at returns over time that the most risky assets i.e. those with a high observed beta do worse than less risky ones. That is to say not only are investors not compensated for taking higher risks they’re actually punished for doing so. Huh?
This is to stand not only large parts of accepted finance theory on its head it suggests that the strategies of most of the world’s institutional investors are very fundamentally wrong. Such a theory isn’t going to be accepted willingly; it’d make a mockery of many finance professors and institutional fund managers. So, understandably, there’s been push-back.
Most of this involves questioning whether or not the theory can be put to practical use? Sure, say the skeptics, you can take whole stock markets, back test data until your circuits fry and ‘prove’ your arguments; but seriously dudes, it’s not possible in the real world.
The paper I’m highlighting this week says it is. The authors, Mr. Benjamin R. Auer and Mr. Frank Schuhmacher, both from the University of Leipzig, Germany, have applied the theory to just stocks that have made up the Dow Jones Industrial Average from 1926 to 2013 and even assuming some punishing transaction costs (1% spread and 0.2% dealing) have found the anomaly persistent over the study period.
Ah but, everything’s changed since the GFC and these historic relationships have broken down since then, right? Wrong, according to Messers Auer and Schuhmacher, the effect appears to have only grown stronger in recent years.
So what causes this? I dealt with this in some detail in previous post which you can access at Explaining the Beta Anomaly. If you don’t have time for that here’s the very short answer. Institutional managers are forced to try and beat benchmarks. The only chance they have of doing so is by buying ‘sexy’ stocks. If too many people try this though the sexy become expensive and the dull become cheap.
If you’re a CFA Institute member you can access the paper using your login at this link Liquid Betting against Beta. If you’re not and you still want the full paper let me know.
N, B. Just because nobody’s doing something doesn’t make it wrong; and just because everybody’s doing something doesn’t make it right. The majority of the world’s population believed, until quite recently, the sun revolved around the earth.
Happy Sunday.