Low risk investing, or betting against beta (BAB), is the idea that if you buy low-risk, low-beta stocks and then short high-risk, high-beta stocks (or industries, depending on your strategy) you can get large risk-adjusted returns without too much active management or stock picking involved. But this contrarian investing strategy is often criticized as being either a value strategy or an industry bet in technical disguise.
“Betting against beta earns positive returns for both industry selection and within industry stock selection, and its risk-adjusted, within-industry returns are especially strong,” write Cliff Asness, Andrea Frazzini, and Lasse Pedersen in their paper Low-Risk Investing without Industry Bets, published in Financial Analysts Journal. “The economically and statistically strong low-risk phenomenon is driven by neither exposure to value nor betting on industries.”
BAB works as an industry bet or industry-neutral strategy: Cliff Asness
Cliff Asness explains that BAB strategies usually sort stocks by beta without taking their industries into account. But since he is trying to show that BAB isn’t making industry bets, he constructed two different models: an industry-neutral BAB portfolio that balances long and short positions within each industry and BAB as a pure industry bet, going long or short on entire industry portfolios.
Both strategies worked, but the industry-neutral BAB strategy had a higher Sharpe ratio than the industry bets, especially in the United States. What’s even more impressive is that the industry-neutral BAB strategy had positive returns in all 49 US industries and 60 out of 70 global industries.
BAB doesn’t benefit from value exposure: Cliff Asness
Showing that BAB isn’t just benefiting from value stocks is fairly straightforward. Cliff Asness shows the ranking of industries that BAB and value would be long or short respectively, and there isn’t much correlation between the two. He says that even when you get down to the stock-picking level, the correlation between value and BAB picks remains too low for one to explain the other (and in the US that exposure drops to basically nothing).
Cliff Asness argues that this is another manifestation of leverage aversion, the notion that low-risk assets have higher risk-adjusted returns because they require leverage to get decent absolute returns and most investors shy away from leverage, creating a market distortion. If leverage aversion is a real effect it would give investors with access to financing and the willingness to borrow a way to consistently come out ahead.