Let’s shake things up – how about I tell you that the age-old theory that risk rewards the brave is all nonsense?
In the world of the UK retail investment market, and contrary to the axiom of financial theory that investors are rewarded for bearing risk (as measured by beta) - it appears that low risk funds have actually outperformed their riskier peers over time.
So what is this anomaly, I hear you ask? Is it persistent? And the key question - does it imply that fund managers should instead focus on risk management rather than outperforming the benchmark?
To test the theory, I decided to plot the performance of all 270 funds in the IA UK All Companies sector against their beta relative to the FTSE All Share index
Looking at graph 1 (see figure 1), you will see that although the R squared is not high, the direction of the trend line tells a lot.
Contrary to traditional financial theory, the graph highlights a negative relationship between beta and returns. This negative trend is further enhanced if we shorten the time period to the most recent two and five year periods (see figures 2 & 3). One should not be surprised by this result, as growth has strongly outperformed value in recent times – it has actually paid off to look for defensive growth characteristics rather than focusing on valuation, as highlighted by the outperformance of the tobacco industry or large consumer companies relative to the FTSE All Share.
(Figure 1)
(Figure 2)
(Figure 3)
When you look at the performance of the underlying funds and break down the IA UK All Companies sector every year by decile, ranked by beta – what you see is a clear indication that over the past five years an investor putting money into the lowest-beta funds in the sector, would have significantly outperformed both its peers and the benchmark, as is clearly highlighted by the table below showing calendar year performance of the different groups since 2011.
How can we explain this outperformance? By looking at underlying holdings, obviously.
Last year’s stellar performance by the likes of Imperial Brands, SABMiller, Reckitt and BT do their bits to highlight how low-beta stocks can actually generate strong returns and outperform the wider market.
It sounds counter intuitive but this phenomenon is called the low-beta anomaly. Contrary to common belief, this is not a phenomenon which has manifested itself given the negative interest rate policy and quantitative easing programmes recently launched by various central banks all over the world. The low-beta anomaly was first observed as early as 1970 by Fisher Black, and in 1972 by Robert Haugen and James Heins. Empirical evidence has accumulated since then and broadly confirms that this low-volatility anomaly persists over time.
Consensus among academics and practitioners popularises three hypotheses to explain the low-beta volatility. The first hypothesis states that investors who demand high returns are leverage constrained and choose to increase their expected return by over allocating to high beta stocks and under allocating to low beta stocks. A second hypothesis is given by behavioural finance. Investors irrationally use high volatility stocks as lotteries; in this framework, investors are implicitly willing to accept lower expected returns by paying a premium to gamble with high volatility stocks. Another plausible behavioural hypothesis attributes the anomaly to analysts’ optimism about more volatile stocks. Equity analysts tend to produce high growth forecasts for high-volatility stocks; this can push up their prices and correspondingly reduce future returns.
Nevertheless, the outperformance of low-beta stocks in themselves do not entirely explain why low-beta UK Equity managers typically outperform their sector peers. Portfolio construction has an equal role to play as the average return of a portfolio is not simply the average sum of the constituents.
Portfolio level effects such as rebalancing and compounding must also be taken into consideration.
Researchers identified a strong correlation between low-beta stocks and high dividend yielders, so that dividends in fact contribute to a substantial part of the outperformance of the low-beta strategy. It makes sense as low beta “boring” stocks must compensate by offering larger dividends; maturing businesses with high visibility in earnings pay dividends whereas growing firms do not.
The compounding effect also has a significant impact on returns. Investors should, by now, be aware that it takes a lot more than a 40 per cent positive return to recover from a 40 per cent downturn. By focusing on low-beta stocks which typically drop less than the index, low-beta UK Equity managers simply enhance this compounding effect.
With all that in mind, there are several reasons as to why low-beta UK Equity managers continue to outperform their sector peers. According to the low-beta anomaly, these managers typically pick stocks which outperform the UK Equity markets, especially as there are constraints on leverage as well as strong behavioural biases. Portfolio construction is another contributor to performance as managers will typically pick stocks with higher income generation and better resilience in down markets.
Ergo, fund selectors should not try to identify funds which are going to outperform their benchmark. They should, instead, focus on how a fund manager will better protect their money. It is an easier task, and also something manageable although less thrilling.