2022 has been an incredibly volatile period for stock markets around the world, as the invasion of Ukraine has added to the lingering uncertainties caused by the Covid pandemic. Beta is a common measure of a stock’s volatility in comparison to the market as a whole.
A common strategy among investors has been to bet against beta (BAB), with investors shorting assets with a high beta, going long on assets with a low beta. The rationale is that assets with higher betas are overpriced and those with lower betas underpriced. This then results in so-called “positive alphas”, which is an indication that the asset is then outperforming the market.
Secret sauce
Research from the University of Luxembourg suggests that the secret to the success of the strategy is the exposure to non-fundamental price pressure from the trading activity of mutual funds.
“High and low beta stocks are differently impacted by data or activities that confuse or misrepresent genuine underlying trends, known as price noises,” the authors explain. “These noises characterize the performance of the BAB strategy over time. For example, when retail investors are caught up in the market euphoria, they are too optimistic, and equity mutual funds experience inflows, which lead to upward price-pressure and subsequent negative returns.”
What’s more, this effect appears to be stronger for high beta stocks, which results in much lower returns. Therefore, when the market performs badly, the BAB strategy tends to return more positive returns precisely because of the short position placed on high beta stocks.
Dynamic strategy
The researchers developed a dynamic trading strategy as a result of these findings that allowed them to hone in on signals from past flows, and indeed past BAB strategies. This approach was able to outperform the market by a factor of 0.71% per month on average. Following positive flows, this figure falls to 1.62%, while during market stress episodes, it rises by 2.14%.
“Until now, the large alphas that BAB portfolios produce have been puzzling for financial economists,” the author concludes. “My explanation that a major part of the excellent performance is due to its exposure to flow-induced price noise is new and interesting. I hope that my results encourage scientists to continue investigating asset pricing anomalies.”
