Betting-Against-Beta is Over

Probably due to post-GFC funding constraints

Almost a decade ago, quant researchers at AQR documented the strange fact that the basic model of asset prices simply did not work. The Capital Asset Pricing Model (CAPM) says that assets that covary more with the market should sport higher returns in order to compensate the marginal investor for the greater risk they pose to her balance sheet. Ie, risk assets with higher betas should have higher expected returns. The excess return associated with higher beta is called the risk premium. This was a counterintuitive and strange result. The quants posited that the reason that the risk premium was compressed was that investors were leverage-constrained to achieve their investment goals; and they therefore bid away the risk premium on the most liquid risky securities: “agents cannot use leverage and, therefore, overweight high-beta assets, causing those assets to offer lower returns.”

Here we show that the betting-against-beta pattern has vanished; CAPM has been working fine over the past decade. We posit that, contra the AQR quants, the original betting-against-beta result was due to too much leverage in the system rather than too little. Under easy financial conditions, risk arbitrageurs could obtain all the leverage they wanted, and they were thus able to bid away risk premia across the board, including that associated with market risk. After the global financial crisis, constraints on intermediary balance sheet elasticity meant that risk arbitrageurs could no longer obtain the leverage they desired, and therefore could no longer bid away the risk premium, with the result that the risk premium associated with market risk has revived. The upshot is that CAPM is back and here to stay as long as the elasticity of intermediary balance sheets remain constrained by the response functions of securities regulators.

We obtain adjusted closing prices and market capitalization for the 500 most liquid US equities (based on a number of penny stock filters). These are the most liquid risk assets in the world and therefore constitute the hardest test case against our claim — if the risk premium has revived for these assets, then the null expectation is that it must’ve revived even more in less liquid risk assets as well.

We first construct a monthly-rebalanced, marketweighted portfolio of these 500 stocks. We then obtain betas using rolling OLS. Finally, we construct a monthly-rebalanced, dollar-neutral long/short portfolio that is long the top decile and short the bottom decile by beta. We show that this “CAPM L/S” portfolio has sported a positive expected return since 2012. We estimate a risk premium of 5.0% per annum associated with one unit of beta risk over this period.

The first figure shows the calendar year return over the past twenty-four years, divided into “the lost decade of US equities”, 2000-2011, and the post-GFC era, 2012-2023. We find that our CAPM L/S returned -1.34% per annum in the earlier period, but has since averaged 2.18% per annum — a change of 3.52% per annum.

In risk-adjusted terms, we find an average calendar year Sharpe ratio of 0.06 in the earlier period, but a very respectable Sharpe of 0.44 since 2012. (Note the composition fallacy at work — the Sharpe ratio for the earlier period is not negative despite the expected return over the period being negative.)

The next figure displays the cumulative daily returns on the CAPM L/S, as well as summary statistics for the same. Clearly, we’re no longer in the world of betting-against-beta.

The next figure shows a scatter plot of mean compounded return over the past decade against beta estimated with returns until December 31, 2011, for all 500 of our stocks. The slope coefficient, which here means the risk premium, is clearly very significant.

Using OLS and robust standard errors, we estimate that the risk premium associated with CAPM beta is 5.0% per annum, which is significantly different from zero at the 1 percent level of significance (t = 5.8).

We have shown that the betting-against-beta trade is over. The revival of CAPM is of some significance to quant researchers and market analysts. It suggests that constraints on the elasticity of intermediary balance sheets have been significant enough to shape broad patterns of fluctuations in risk premia and asset prices. This is consistent with other evidence such as dollar strength as a proxy for financial conditions, and violations of covered interest rate parity.