Downward-sloping security market line: a sign the end is nigh?

CAPM / Alpha Theory 29 Apr 2007

Here is yet more evidence that high volatility stocks do not necessarily out perform low volatility stocks.  A new research paper by the brainiacs at Dutch institutional investment manager Robeco shows that not only don’t high-vol stocks outperform low-vol stocks, but they actually underperform them.  You heard right.  The security market line (SML) slopes down, not up as the researchers illustrate in the chart below.

If this isn’t a sign that the end is nigh, we don’t know what is.  As Dan Akroyd and Bill Murray warned us all in the movie Ghostbusters, the End involves: “Fire and brimstone coming down from the sky…Rivers and seas boiling…Forty years of darkness…Dogs and cats living together…and a downward sloping SML“.

But wait! There may be an explanation.  The authors blame this observation on several possible phenomenon.

One is that it’s difficult for many investors to lever up low beta stocks to arbitrage away this anomaly.  In fact, mutual funds aren’t even allowed to use leverage.   Instead, mutual funds have to buy inherently risky stocks if they want to hit the ball out of the park.  So they fall over themselves trying to load up on these stocks – bidding up their prices and reducing potential returns below “fair (CAPM) value”.  As a result, high Sharpe ratio, low beta stocks are destined to stay that way.

LBO funds, the authors note, are an exception.  And this might help explain the huge success of LBOs.  We note that this raises an intriguing possibility: the recent phenomenal growth of private equity is a result of this “inverted SML”.

The other possible explanation lies in human behavior.  Investors, it has been said, choose the safety of diversification for the core of their portfolio in order to keep them out of poverty.  But they prefer the upside of concentration when trying to get rich.  This would also bid up high beta stocks, thus pushing down their returns.

At the end of the day, what can an investor do if she wants to exploit this apparent anomaly, but does not want to take on leverage?  The authors suggest that levering low volatility stocks can be achieved by simply reducing cash (or bonds) and increasing equity allocation.  In other words, a portfolio of 50% cash and 50% equity has the same volatility and return as a portfolio of 25% cash and 75% equity – as long as that equity component is exactly a third less volatile and produces exactly a third less return.  If that lower volatility portfolio produces more than a third less return (as this study suggests it should) then the investor is better off.

Score one for Fama & French.  Apparently, the (risk adjusted) out-performance of low volatility stocks is partly explained by value and small cap factors.  Say the authors:

“The FF-adjustment has the biggest impact for the US, where the alpha drops from 13.8% to 7.0%. For Europe the alpha is lowered to 7.4% from 10.2%. The alpha is least affected for Japan, at 9.8% versus 10.5%. From these results we can conclude that the volatility effect is reduced, but does not disappear after applying the FF-adjustment.”

The conclusion for institutional investors is quite obvious, don’t be afraid of leverage.  On the contrary, lever-up low volatility stocks:

“However, for investors interested in high Sharpe ratio investment opportunities such as pension funds, it may be much easier to benefit from the volatility effect, by applying leverage within their asset mix. These investors could simply decide to shift from a given allocation to traditional stocks to a higher allocation to low risk stocks, by reducing the weight of bonds…we recommend that absolute return investors distinguish between low risk, high risk and traditional stocks as separate asset classes, just like they distinguish between value versus growth stocks and large-cap versus small-cap stocks in their strategic asset allocation decision making.”

Hmm. Seems possible enough.  This may not be the end of the world after all.

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