Betting Against Beta Factor in Stocks

In the real world, some investors are prohibited from using leverage, and other investors’ leverage is limited by margin requirements. Therefore, they over-weigh risky stocks instead of using leverage, which makes these stocks more expensive. This behavior suggests that high-beta (risky) stocks should deliver lower risk-adjusted returns than low-beta stocks. Investors not limited in leverage (arbitrageurs) could exploit this inefficiency by “betting against beta”, i.e., by going long on a portfolio of low-beta stocks, leveraged to a beta of 1, and short on a portfolio of high-beta stocks, de-leveraged to a beta of 1.

This long-short portfolio delivers substantial risk-adjusted returns and works well for the US and Global equities. Still, nevertheless, caution is needed in implementing this strategy (costs, slippage, etc.) as research also suggests that this effect is the strongest in small-cap stocks. Research also shows that the effect isn’t limited to stocks but also works well in other asset classes (even between asset classes).

Fundamental reason

The reason for the anomaly functionality was already stated in the short description – a lot of the investors are prohibited from using leverage, and their only way to achieve higher returns is to buy more risky stocks, which is the main cause for their overvaluation. Investors not facing these constraints could earn above-average returns by exploiting this phenomenon.

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Markets Traded
equities

Financial instruments
stocks

Confidence in anomaly's validity
Moderately Strong

Backtest period from source paper
1926-2009

Notes to Confidence in Anomaly's Validity

Indicative Performance
8.86%

Period of Rebalancing
Monthly

Notes to Indicative Performance

per annum, annualized monthly return (geometrically) of 0.71% (from table III – return for long short portfolio)


Notes to Period of Rebalancing

Estimated Volatility
11.5%

Number of Traded Instruments
1000

Notes to Estimated Volatility

Notes to Number of Traded Instruments

more or less, it depends on investor’s need for diversification


Maximum Drawdown
0%

Complexity Evaluation
Complex strategy

Notes to Maximum drawdown

not stated


Notes to Complexity Evaluation

Sharpe Ratio
0.42

Simple trading strategy

The investment universe consists of all stocks from the CRSP database. The beta for each stock is calculated with respect to the MSCI US Equity Index using a 1-year rolling window. Stocks are then ranked in ascending order on the basis of their estimated beta. The ranked stocks are assigned to one of two portfolios: low beta and high beta. Securities are weighted by the ranked betas, and portfolios are rebalanced every calendar month. Both portfolios are rescaled to have a beta of one at portfolio formation. The “Betting-Against-Beta” is the zero-cost zero-beta portfolio that is long on the low-beta portfolio and short on the high-beta portfolio. There are a lot of simple modifications (like going long on the bottom beta decile and short on the top beta decile), which could probably improve the strategy’s performance.

Hedge for stocks during bear markets

Partially - Low beta stocks (low-risk stocks) are usually safer during turmoil, and Beta Factor in a long-short variant can be used as a portfolio hedge against equity risk. However, caution should be used as the popularity of betting-against-beta investing could move valuation (measured by common valuation ratios like P/E, P/B, P/CF, etc.) of low beta stocks into excessive-high (compared to neutral market valuation). This popularity of betting-against-beta factor investing and high valuation of low beta stocks can be then detrimental to their performance during market stress.

Source paper
Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers

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