Background

Many empirical studies have shown that a value style approach to share investing has consistently outperformed growth investing – and with less risk. Other studies have shown that lower volatility portfolios, particularly lower beta portfolios, outperform higher beta portfolios.  Concentrated equity portfolios have also proven to outperform their more diversified counterparts.

If value, lower beta and concentrated portfolios have consistently outperformed in the past, then isn’t it only a matter of time before investors arbitrage this away? If this was true, then these ‘anomalies’ should have disappeared a very long time ago as they have been documented for many years. In fact, these so called ‘anomalies’ are a permanent feature of share markets.

The first article looked at the value investing anomaly. This article focuses on lower beta portfolios.

Lower beta portfolios outperform higher beta portfolios

There have been numerous empirical studies showing that lower volatility portfolios, and in particular, lower beta portfolios, outperform higher beta portfolios.  This phenomenon is widespread and applies to most equity markets, including the US and Australia.

Clearly, this is contrary to the Efficient Market Hypothesis and the well-known investment axiom of “the higher the risk, the higher the return”.

Certainly, as shown above, as value portfolios tend to have a lower beta and have outperformed in the long run, value is one potential subset of lower beta portfolios.

A quote from Eugene F. Fama and Kenneth R. French (American economist and Nobel laureate in Economics, and Professor of Finance respectively, known for their work on portfolio theory and asset pricing, both theoretical and empirical) from one of their papers in the Journal of Economic Perspectives which was published in August 2004 provides a succinct summary of our view.

“…funds that concentrate on low beta stocks, small stocks, or value stocks will tend to produce positive abnormal returns… even when the fund managers have no special talent for picking winners.”[1]

MSCI produces minimum volatility returns based on the MSCI index constituents, which is a proxy for low beta portfolios.  It is constructed using the Barra risk model and is subject to holding constraints by stock and sector.

As table 1 shows, the MSCI Minimum Volatility Index has outperformed the MSCI broader market index by 0.38% pa – despite targeting lower beta (or lower risk) portfolios by construction.

For completeness, comparable numbers were produced for global equities using the MSCI World Index.  As can be seen in table 2, the numbers show an even more compelling story than Australia, with the MSCI Minimum Volatility Index outperforming the MSCI by 1.52% pa.

The reason why the numbers are more pronounced for the global market may be explained by the greater number of stocks to choose from while still constructing the portfolio within the portfolio constraints.

To test how meaningful these results are, t-statistics have also been calculated in table 3. The t-statistics are not as convincing as they were for value, but they are still on the right side of the ledger.  What they do imply is that a longer time frame is required for the outperformance to come through than the time frame required for value.

Why does low beta investing work?

There are various theories as to why lower beta (or lower risk) stocks tend to outperform higher beta stocks.  The theory that makes the most sense to us is the ‘lottery effect’ of high beta stocks.  This is where investors focus only on the upside or ‘blue sky’ scenarios and bid up the price of a stock on the hope that it could be a ‘ten bagger’ (ie worth 10 times its original amount) without fully incorporating the impact of the potential downside.  This also leads to some investors disregarding the steady, boring stocks as they chase the ‘sexy’ stocks that could make them rich – but in most cases never do… just like the lottery.  We have seen this occur many times in the past.

Another theory is that the lower beta stocks are on average inherently boring and conservative and have good stable cash flows.  As such, they tend to be higher dividend-paying stocks. These dividends are actually cash returns that help to underpin portfolio returns.

Table 4 provides a list of the top 10 lowest beta stocks and top 10 highest beta stocks in the ASX 50 Index as at January 2014.  The names in each list should not be a surprise – reflecting largely the nature of the industries the stocks are in.

One more theory that has emerged recently as to why low beta stocks outperform is the impact of ‘index aware’ investing, and portfolio manager bonuses rewarding more ‘risky’ behaviour in their stock selection – as they don’t get negative bonuses.  It is by virtue of managing portfolios against an index weight, portfolio managers may be compelled to hold higher beta stocks whether they like it or not, and as such, leads to inefficient pricing.  In conjunction with this, the ‘lottery effect’ discussed above comes into play, as some portfolio managers look to achieve big short-term outperformance by taking active positions in higher beta stocks, so as to receive big bonuses.

Chart 1, sourced from Nardin L Baker and Robert A Haugen (in their paper Low Risk Stocks Outperform within All Observable Markets of the World, 2012), depicts this notion graphically, albeit utilising volatility as the risk measure. The ideas are comparable. Given equity markets are considered to rise over time, a manager paid a bonus for outperformance may skew the portfolio to those stocks expected to rise more than the market – ie higher beta stocks.

Other potential explanations outlined by Baker and Haugen in their paper include lower volatility stocks are harder sell to a portfolio manager or investment committee. This is a function of the tendency for low beta and low volatility stocks to have a boring narrative relative to higher beta/higher volatility names and is suggested to have an impact on institution stock selection.

Baker and Haugen conducted research on the largest 1,000 stocks in the US between 2000 and 2009. They categorised these into ten deciles by market capitalisation, from the smallest (on the left in chart 2) to the largest (on the far right). The blue bar shows the stocks that institutions own more of, and the red bar shows the stocks that institutions own less of, within each capitalisation decile. Their research showed that institutions tended to own more of the higher volatility stocks – regardless of market capitalisation. The very smallest stocks were the only exception, where it was lineball.

The more volatile stocks also tend to have greater intensity of broking analyst coverage and greater news coverage.

However, while low beta investing does work in the long run, there are times when it can be in the wilderness for some time, as noted by the lower t-statistics.  These are typically when the market is in the latter stages of a massive bull run or when the market is driven by speculative fads which typically mean the boring, but reliable, low beta stocks can be overlooked by investors for some time.

Intuitively, why will value and low beta continue to outperform?

If value as well as lower beta has consistently outperformed in the past and has done so for less risk, then isn’t it only a matter of time before investors arbitrage this away?  If this was true, then these ‘anomalies’ should have disappeared a very long time ago, as they have been well known and documented for many years.  In fact, these so-called anomalies are really a permanent feature of the share markets.

The real answer for why value investing and lower beta investing has outperformed and why it should continue to do so, may be answered by delving into behavioural finance ie the psychological decision making of investors.

Time and time again, history has repeated itself with the various booms and busts of share markets, and speculative bubbles within the share market itself as investors chase the latest fads and ‘fashionable’ stocks.  In each case, the markets have corrected themselves.  There are numerous examples of varying degrees that have occurred in individual stocks, individual sectors, in whole countries and regions.  They have occurred in so called ‘growth’ stocks which become ‘high beta’ stocks as they rise quickly relative to the market in a short period of time.

We can even go back to the 18^th Century for such examples as the ‘South Sea Company bubble’ in London.  It would seem that investors never learn from history.

In the United States, in the early 1970s there were the ‘Nifty Fifty’ stocks that were the favoured large stocks that raced up to excessive prices, while many of the other stocks were at bargain prices.  In Australia, there was the Poseidon boom in 1970, the speculative bubble in casino stocks in 1996, and short periods of heightened speculation in certain types of low- quality commodity-related stocks since 2003 and up to late 2010.

We only need to recall the Telecommunications/Media/Technology (TMT) boom of 2000 and its subsequent bust for a very dramatic example of when so-called growth and/or high beta stocks moved to stratospheric price levels, while solid companies with real cash flows were sold down heavily as investors chased the latest hot stock.

In each and every case, a great opportunity was created for those investors who stayed with value and did not get caught up in the hype. These opportunities will present themselves again well into the future due to the psychology of investors as inevitably, history will repeat itself again and again.

The next and final instalment from this three-part series will explore the anomaly of the outperformance of concentrated portfolios over their more diversified counterparts.

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[1] Source: Journal of Economic Perspectives – Volume 18, Number 3 – Summer 2004

Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Concentrated Fund (TASCF) ARSN 143 598 556 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (TAML). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. Reference to individual stocks in this material neither promise that the stocks will be incorporated into TASCF nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

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