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2016-06-02 08:17:57
Jun 1st 2016, 15:55 by Buttonwood
RISK is linked to reward; it is virtually the first lesson one learns about
finance. Safe assets pay low returns; if you want higher returns, you have to
risk your capital. Academics have been examining these issues for decades, and
have come up with such insights as the capital asset pricing model (CAPM) and
the efficient market hypothesis. In turn, investors have applied their insights
to the market. The techniques they have adopted may have changed the nature of
the market. Risk and reward may not be as securely linked as they used to be.
Two papers in the spring Journal of Portfolio Management bring these issues to
light. The first Risk Neglect in Equity Markets by Malcolm Baker of the
Harvard Business School looks at an obvious flaw in the CAPM. The model
suggests that stocks which are more volatile than the overall market (high beta
in the jargon) should display higher returns while stocks that are more stable
(low beta) should deliver lower returns. More risk means more reward.
But that is not what has happened. Mr Baker assembles two portfolios from 1967;
one consists of the 30% of US stocks with the lowest beta; another of the 30%
with the highest beta (the portfolios are adjusted as betas change). By the end
of the period, $1 in the low-beta portfolio had grown to $190, while the
high-beta portfolio rose to just $18. The difference in compound returns is
huge 5.5% a year. The low-beta portfolio is a lot less volatile and the maximum
drawdown (peak-to-trough loss) is 35% compared with 75% for the high-beta
portfolio.
Think about that; low risk meant higher reward. It was the equivalent of
finding $20 notes lying on the street.
When you move to the world of asset classes, however, the traditional rule
held; over the entire period, equities returned 10.9% a year while safe
Treasury bills paid just 5%. Investors did get paid for owning risk.
Was this a fluke? Mr Baker is not the first to notice the anomaly. One of
finance s best-known academics, Fisher Black, wrote up the low-beta anomaly in
1993. That means the period since his paper was published is out of sample
and thus a good test of the hypothesis. Sure enough, low-beta stocks have
outperformed since then, despite a period in the late 1990s when, thanks to the
dotcom bubble, high-beta stocks were all the rage.
Why might this be? Veteran readers might recall a column from 2012 which
explained the outperformance in terms of low beta. AQR, a fund management
group, explained the low-beta effect in terms of institutional constraints.
Fund managers want to beat the market and deliver higher than average returns;
so they buy high-beta stocks, as academic theory suggests. This makes high-beta
stocks too pricey and drives down their returns. The answer should be to buy
low-beta stocks and combine them with leverage. But investors are generally
constrained from using borrowed money. So the anomaly persists.
Mr Baker thinks part of the reason that private equity has been successful is
down to this strategy; the likes of Blackstone and KKR are buying less volatile
(cash-generating) businesses with borrowed money.
The second paper ("Index-Linked Investing A Curse for the Stability of
Financial Markets around the Globe?" by Lidia Bolla, Alexander Kohler and Hagen
Wittig) deals with tracker funds, a product your blogger has enthusiasm for.
Tracker funds have been around for 40 years but took their time to gain market
share despite the obvious attractions of their low costs; in recent years,
exchange traded funds (ETFs) have surged in popularity, taking the tracker
share of the market market to more than a third. The efficient market
hypothesis suggests that it is very hard for active managers (those who pick
stocks) to beat the market after costs because all the information is already
reflected in market prices; what will move prices in future is news which, by
definition, cannot be known in advance.
Some have worried, however, that tracker funds dilute the purpose of the
stockmarket, which is to allocate capital to the most attractive companies.
Trackers just buy shares in proportion to their market weight. The paper looks
at the potential for the rise of index funds to cause herding. As people pile
in and out of index ETFs, all shares will move together as those who run the
index funds either buy, or sell, all the component stocks of the benchmark.
Sure enough, that is what the paper did discover:
We found a substantial increase in the co-movement of stocks with respect to
trading patterns, price returns and liquidity risks within all markets
analysed. Furthermore, we investigated whether the increase in risk
commonalities can be attributed to the growth in index-linked investing, and we
found statistically significant and economically relevant evidence that the
growth in index-linked investing is related to the substantial increase in risk
commonalities.
The irony here is that a shift by investors to reduce their individual risk
(that they pick an underperforming fund manager) might end up increasing risk
in aggregate. Does this diminish your blogger s enthusiasm for trackers? No.
First, the figures still show that active managers do not beat the markets over
the long term. One can always find some that have in the past, but they cannot
be relied upon to do so in future. Second, the charges levied by active
managers have a corrosive effect over the longer term that is a much greater
risk to investors wealth than occasional bouts of herd-driven volatility.
Some people in the finance industry have a sniffy attitude towards academics.
(My favourite, probably apocryphal, exchange is as follows. Hedge fund manager
to academic: If you re so smart, why aren t you rich? Academic to fund
manager: If you re so rich, why aren t you smart? ) But academics play a vital
role; they are a generally unbiased check on the pretensions of financial
practitioners, with enough technical knowledge to cut through the jargon with
which Wall Street can confuse the investing public. Academic views will change
over time; of course they will. But we should be glad they are around.