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Low-Risk Investing Without Industry Bets by SSRN

Clifford S. Asness

AQR Capital Management, LLC

Andrea Frazzini

AQR Capital Management, LLC

Lasse Heje Pedersen

New York University (NYU) – Department of Finance; Copenhagen Business School; AQR Capital Management, LLC; Centre for Economic Policy Research (CEPR)

May 10, 2013


The strategy of buying safe low-beta stocks while shorting (or underweighting) riskier high-beta stocks has been shown to deliver significant risk-adjusted returns. However, it has been suggested that such “low-risk investing” delivers high returns primarily due to its industry bet, favoring a slowly changing set of stodgy, stable industries and disliking their opposites. We refute this. We show that a betting against beta (BAB) strategy has delivered positive returns both as an industry-neutral bet within each industry and as a pure bet across industries. In fact, the industry-neutral BAB strategy has performed stronger than the BAB strategy that only bets across industries and it has delivered positive returns in each of 49 U.S. industries and in 61 of 70 global industries. Our findings are consistent with the leverage aversion theory for why low beta investing is effective.

Low-Risk Investing Without Industry Bets – Introduction

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 long stodgy (but perhaps ultimately profitable!) industries and by an assumption that the returns are driven by value effects. For example:

…low volatility strategies have substantial industry tilts that, when removed, substantially reduce volatility-adjusted returns. Second, low volatility strategies have higher exposure to the value premium — 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 and away 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.

In particular, we construct Betting Against Beta (BAB) factors that invest long in a portfolio of low-beta stocks while short selling a portfolio of high-beta stocks (following Frazzini and Pedersen (2010)). To make the BAB factors market neutral, the safe stocks on long side of the portfolio are leveraged to a beta of 1 and, similarly, the short side of the portfolio is deleveraged to a beta of 1. Hence, the overall beta of a BAB factor is zero so that its performance can be ascribed to the efficacy of low-risk investing, not market movements.

The “regular” BAB factor in the literature is constructed by sorting stocks on their beta without regard to industries — hence, its performance could be driven by industry bets, or stock selection within industry, or a combination. To determine which is more important, we consider the following new BAB factors, constructed to have minimum and maximum industry bets:

  • Industry-Neutral BAB. To see whether BAB works when we eliminate the effects of industry tilts, we construct an industry-neutral BAB factor by going long and short stocks in a balanced way within each industry. This way, we compute a BAB factor for each industry and diversify across these to produce an overall industry-neutral BAB factor.
  • BAB as a Pure Industry Bet. To see how well low-risk investing does as a pure industry bet, we consider a BAB strategy that goes long and short industry portfolios. This is an extreme form of the low-risk strategy fitting the popular perception, one that only makes big bets on industries.

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