A Market Leverage as an Explanation of Low Volatility Anomaly

A related paper has been added to:

#7 – Volatility Effect in Stocks – Long-Only Version

#77 – Beta Factor in Stocks
#78 – Beta Factor in Country Equity Indexes

Authors: Andricopoulos

Title: Leverage As A Weapon of Mass Shareholder-Value Destruction; Another Look at the Low-Beta Anomaly

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2859363


The 'low-beta' or 'low-volatility anomaly' is one of the most researched in the field of 'alternative beta'. Despite strong published evidence going back to the 1970s that high beta/volatility stocks underperform relative to expectations generated by the Capital Asset Pricing Model (CAPM), the anomaly still persists. The explanations given for this are all behavioural; that investor biases lead to overpricing of high volatility stocks. This paper shows that investor biases cannot be the explanation for the anomaly. Instead, it is proposed that the anomaly stems from a destruction of shareholder value. The strong implication is that the more market leverage a firm has, the more shareholder value is destroyed. Although the prevailing view for a long time has been that adding debt is good for shareholders, making balance sheets more 'efficient', there is in fact a considerable volume of evidence that the opposite is true; evidence which has been incorrectly interpreted for many years. Some possible mechanisms for this shareholder-value destruction are proposed.

Notable quotations from the academic research paper:

"There is a large body of evidence that stocks with a low volatility persistently outperform versus stocks with a high volatility on a risk-adjusted basis, and in many cases on an absolute basis. Current explanations focus on behavioral reasons that could lead to mispricings (this will be given the umbrella term, the 'mispricing argument'). For example, it is suggested that mutual fund managers have a bias in favor of high beta stocks. Whilst these may be true; the major contribution of this paper is to show why these arguments cannot explain the phenomenon. The only remaining explanation is that high beta is highly correlated to a future shareholder-value destruction. Some
ways that this could happen are explored.

Empirical data are then also presented which suggests that it is high beta and not high idiosyncratic volatility that leads to this shareholder value destruction. One way of looking at this is to say that companies which outperform based on luck (the market going up) destroy shareholder value relative to those for which any outperformance is based on manager skill.

The signi cance of this work is two-fold. From a corporate structure point of view, there has long been the idea that adding debt can make a balance sheet more efficient, and that it is in the interest of shareholders. This finding implies that the opposite is true. Adding leverage, on average, leads to more shareholder value being destroyed. The suggestion here is that the reasons for this are largely to do with manager behavior, but could also have other causes. Despite the low-beta anomaly being known about since the 1970s, the prevailing (behaviorally-driven mispricing) explanations have served, for many years, to hide the damage caused by leverage to shareholder value. From an investment point of view, the implication is that the low-beta anomaly will persist indefinitely; or at least until the causes are discovered and corporate practices are changed to counteract them. If the cause of the anomaly were related to pricing, then the mispricing would no longer exist if enough investors bet against it. If, as this paper shows, it is due to future shareholder value destruction, then there is no reason that low-beta stocks will not continue to out-perform high-beta stocks in the future. Although at times a market-neutral low-beta vs high-beta portfolio can be relatively over-valued or under-valued by market sentiment, in the long term it should always have positive return."

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