One cornerstone of finance theory is that investors demand return in exchange for assuming risk. As a consequence, the long-term returns of an investment strategy should be commensurate with the risks the strategy takes. This proposition sounds reasonable and intuitive, but it remains controversial. As both academics and practitioners have noted, there appear to be some anomalies, i.e., investment strategies that generate returns greater than expected in light of their perceived risks.
One example that has generated considerable discussion recently in both academic and practitioner circles is what one might call the “beta puzzle”: Portfolios of low beta stocks have historically matched or beaten broader equity market returns, and have done so with significantly lower volatility. At the same time, high beta stocks have significantly underperformed, exhibiting lower returns while appearing to take much more risk.
A number of strategies have been proposed to take advantage of this perceived inefficiency, from risk parity to minimum variance portfolios. In each case, the investment thesis hinges on the belief that the counterintuitive performance of high and low beta stocks is an exploitable anomaly. In this paper we argue that this puzzling phenomenon is not an anomaly at all, but, more simply, stems from a misunderstanding of risk. In examining the beta puzzle and what lies behind it, we provide a framework for thinking about risk and return that can offer insight into a wide variety of investment strategies, from low-beta equity portfolios to levered ETFs and hedge funds.
The Puzzle
Let’s begin by taking a look at the empirical data behind the beta puzzle. Exhibit 1 shows the performance of portfolios of high and low beta large-cap U.S. stocks.
As Exhibit 1 shows, the portfolio of low beta stocks has outperformed the broader market, with substantially lower realized volatility and smaller drawdown. The high beta portfolio has underperformed the market, and done so with substantially higher volatility and larger drawdown. This is the essence of the beta puzzle: why should the low-risk asset have no compensating reduction in performance, while the high-risk asset (which should be compensated for its additional risk) underperforms?
This phenomenon is not limited to the U.S.; the same pattern can be seen for global equities (Exhibit 2). As in the U.S., the global low beta portfolio provides a much better return than high beta despite appearing to carry much lower risk.
Proposed Explanation(s)
This puzzle has been widely discussed, and several explanations have been offered. To us, the most interesting of them theorizes that high beta assets trade at a premium because they provide implicit leverage to investors who are
Link to the entire white paper.
One example that has generated considerable discussion recently in both academic and practitioner circles is what one might call the “beta puzzle”: Portfolios of low beta stocks have historically matched or beaten broader equity market returns, and have done so with significantly lower volatility. At the same time, high beta stocks have significantly underperformed, exhibiting lower returns while appearing to take much more risk.
A number of strategies have been proposed to take advantage of this perceived inefficiency, from risk parity to minimum variance portfolios. In each case, the investment thesis hinges on the belief that the counterintuitive performance of high and low beta stocks is an exploitable anomaly. In this paper we argue that this puzzling phenomenon is not an anomaly at all, but, more simply, stems from a misunderstanding of risk. In examining the beta puzzle and what lies behind it, we provide a framework for thinking about risk and return that can offer insight into a wide variety of investment strategies, from low-beta equity portfolios to levered ETFs and hedge funds.
The Puzzle
Let’s begin by taking a look at the empirical data behind the beta puzzle. Exhibit 1 shows the performance of portfolios of high and low beta large-cap U.S. stocks.
As Exhibit 1 shows, the portfolio of low beta stocks has outperformed the broader market, with substantially lower realized volatility and smaller drawdown. The high beta portfolio has underperformed the market, and done so with substantially higher volatility and larger drawdown. This is the essence of the beta puzzle: why should the low-risk asset have no compensating reduction in performance, while the high-risk asset (which should be compensated for its additional risk) underperforms?
This phenomenon is not limited to the U.S.; the same pattern can be seen for global equities (Exhibit 2). As in the U.S., the global low beta portfolio provides a much better return than high beta despite appearing to carry much lower risk.
Proposed Explanation(s)
This puzzle has been widely discussed, and several explanations have been offered. To us, the most interesting of them theorizes that high beta assets trade at a premium because they provide implicit leverage to investors who are
Link to the entire white paper.
