Scalper1 News
Summary Beta is a common measure of a stock’s risk, and investing in low-beta stocks (low-risk stocks) has become a highly popular investment strategy among institutional investors today. Our new research shows that betas significantly change over time and seem to depend on the stocks’ ownership structure and how frequently the stocks trade. Low-beta stocks are often thinly traded; when investors buy into low-beta stocks, both their prices and betas increase. The opposite can occur when investors try to exit. Increases in institutional ownership breadth and the stocks’ turnover temporarily increase the stocks’ CAPM beta. The figure below shows the regression coefficients when future changes in stocks’ betas are regressed on changes in ownership breadth and turnover. Solid lines give the regression coefficients; dashed lines present 95% confidence intervals. Source: P. Jylhä, M. Suominen and T. Tomunen, “Beta Bubbles,” working paper 2015 Betting against beta All MBA and finance students learn in their basic finance courses the Capital Asset Pricing Model (CAPM), a theory largely attributable to the Nobel Prize winner William Sharpe. This theory states that riskier assets in equilibrium should earn higher returns, and that the relevant measure for a stock’s risk should be its “beta,” a measure of the stock’s systematic risk. Technically, a stock’s beta equals its correlation with the stock market index, scaled by the ratio of its volatility to the market index volatility. All well in theory, but in practice the CAPM has failed miserably. In real life, stocks with the higher risk measures, i.e., the high-beta stocks, have over the recent decades systematically earned lower returns than the low-beta stocks. In fact, investing in low-beta stocks has become a highly popular investment strategy in the financial market, one that is today aggressively marketed to all major institutional investors. Be careful: Betas do not measure what you think they measure In a recent working paper “Beta Bubbles,” written together with Petri Jylhä from Imperial College and Tuomas Tomunen from Columbia University, we suggest a potential reason why the logically well-motivated CAPM fails to work in practice. Most importantly, we show that the stock’s beta in reality seems to measure not only the stock’s level of risk, but also how frequently it is being traded. We study the US stock markets (NYSE and NASDAQ) starting from 1970s, and calculate the stocks’ betas annually from daily data using the Scholes-Williams (1977) method. We find that the low-beta stocks are commonly held by few passive long-term investors. These stocks have low average turnover; in fact on nearly 70% of the days, their trading volume is less than 0.1% of the stocks’ market capitalization. Intuitively, these stocks are so rarely traded that they rarely co-move with the market . This does not necessarily mean that the low-beta stocks are less risky, just that the traditional risk measure beta fails to measure their risk. The low-beta stocks are more prone to jumps, i.e. large market revaluations of their value. High-beta stocks, in turn, are owned by active, short-horizon investors that continuously trade and monitor the market. These short-horizon investors’ entry and exit from the stock market seems also to occur in tandem with the returns of the entire market. For both reasons, stocks owned by short-horizon investors co-move highly with the market. As the high-beta stocks are also more widely held, their risks are more evenly distributed amongst investors and the investors require less return from holding them. Hence the poor future returns to the high-beta stocks. Importantly, the stocks’ betas change over time as the stocks’ popularity changes. For instance, 20% of the stocks in the lowest-beta decile (the 10% of the stocks with the lowest beta) had an above median beta in the previous year. When a stock goes out of fashion and institutions sell the stock, we find that its beta declines. When a stock becomes popular among the active institutional investors, its beta rises. Low beta bets make sense – but prudence required The stocks in the lowest-beta decile are on average thinly owned and thinly traded. As many of them are unpopular among investors today, they, in principle, make up for great investments. However, as the low-beta investing has now become a popular investment theme, there is large risk that an investor investing in low-beta stocks today is in for a big surprise. The investor may find that the prices of low-beta stocks run up as he tries to take positions in these stocks. After all, these are commonly illiquid and thinly-traded stocks. Secondly, they may find that these stocks’ betas increase, as according to our working paper, the betas are a function of the investor population and the betas increase as the number of investors increase. Thirdly, the investors investing today in low-beta stocks should be expecting that these stocks’ prices drop vastly when all the investors following the low-beta investment theme today eventually try to get rid of their former low (now higher) beta stocks. So indeed, there is reason to be careful with your low-beta bets. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
Scalper1 News