Cliff Asness: Low-risk investing is based on the idea that safer stocks deliver higher risk-adjusted returns than riskier stocks. This was first documented by Black, Jensen, and Scholes (1972), who found that the security market line was flat relative to the Capital Asset Pricing Model (CAPM).However, for many the intuition behind low-risk investing in stocks is captured in going longs today (but perhaps ultimately profitable!) industries and by an assumption that the returns are driven by value effects. For example:
— Shah (Dimensional Fund Advisors, 2011)
While there is nothing per se wrong with a factor that bets on industries, the tone of this criticism often conveys the idea that such bets, particularly when passive (going the same direction for long periods), are perhaps either the result of path-dependent data mining or that industry bets will somehow be particularly dangerous going forward. In any event, it’s a common sentiment regarding these strategies and it is meant to call into question their robustness and efficacy.
We explicitly test how much of the benefit of low-risk investing comes from tilts toward andaway from industries versus stock tilts within an industry. We find that both types of low-risk investing work. However, counter to conventional wisdom, we find that low-risk investing is not driven by low-risk industries — not close — and is not driven by the value effect. Among all the low-risk strategies that we consider, the best ones take no industry bets at all!
There are many closely related forms of low-risk investing. Some focus on market beta (Black, Jensen, and Scholes (1972), Frazzini and Pedersen (2010)), some focus on total volatility(e.g., Baker, Bradley, and Wurgler (2011)), some on residual volatility (e.g., Falkenstein (1994),Ang et. al. (2006, 2009)), and some on still other related measures. We focus on market beta since this is the original measure which is linked to economic theory.
Full report from Cliff Asness on low risk investing below