This In Practice piece gives a practitioner’s perspective on the article “Betting against Beta with Bonds: Worry or Love the Steepener?” by J. Benson Durham, published in the November/December 2016 issue of the Financial Analysts Journal.
What’s the Investment Issue?
“Low risk” (or “low vol”) has entered the vernacular of both institutional and retail investors. It is easy to see why: A growing library of evidence suggests that low-risk investing delivers superior investment performance. So, low-risk investing has caught the imagination of investors, particularly because it departs from modern portfolio theory, which contends that lower risk should be associated with lower returns.
Low-risk strategies can take a number of forms, of which “betting against beta” (BAB) is one. In essence, BAB involves taking a short position in assets with higher betas and taking a leveraged long position in assets with lower betas. The idea behind this strategy is that higher beta assets are overpriced, probably because mutual funds tend to overweight their portfolios towards higher beta assets in a bid to increase their market exposure and enhance returns.But while BAB is growing in popularity in equity markets, the literature on low-risk investing in other markets, such as fixed income, currencies, and commodities, is far less extensive.
How Does the Author Tackle This Issue?
The author decided to focus on BAB using government bonds (BABgov), which is not only an underresearched strategy but also one that has previously displayed very high Sharpe ratios.
The first contribution of this study is to explore the extent to which BABgov profits are an explainable anomaly by addressing shortcomings of prior research. Previous studies have used the capital asset pricing model (CAPM) as the asset-pricing framework, but the author contends that term-structure models are better frameworks for bonds. In addition, previous studies have not addressed coskewness, which captures how a security’s risk moves in relation to market risk.
The second contribution of this study is to considerably expand the scope of previous BABgov studies, as the author examined 20 markets outside the United States.
What Are the Findings?
Previous studies have indicated that the effect of BABgov on returns is as compelling as the effect of size, value, and momentum. This study confirms that BABgov is largely robust over time, with monthly excess returns and Sharpe ratios that are considerably higher than those found in previous BABgov studies. The exception is the recent period of unconventional monetary policy, during which BABgov returns were lower.
However, investors who are interested in BABgov should proceed cautiously. Although the study suggests that BABgov is a source of alpha, this strategy incurs substantial and offsetting systematic risk. The author notes that BABgov seems to have as much systematic risk as a simple strategy of levering up the shortest maturities.
In addition, although BABgov is found to produce alpha, it does so primarily for the US market. None of the results for the 20 non-US markets match those for the United States, although BABgov demonstrated robustness to varying degrees in two-thirds of the non-US markets. And, similar to the US results, non-US results show that BABgov entails considerable systematic risk.
Finally, there is evidence that BABgov in the United States is primarily a “bear steepener.” That is, the strategy works better when short-term and long-term rates decouple, usually signalling or reflecting a bearish economic outlook.
What Are the Implications for Investors and Investment Professionals?
From an asset allocation perspective, BABgov could play a similar role to a passive fixed-income allocation in the United States. However, it would probably not be an effective substitute for a global fixed-income allocation given the difficulty of using government bonds in many countries outside the United States, where sovereign bonds may not match US Treasuries.
In addition, investment firms should be careful about how they position and market this strategy, particularly to less sophisticated investors. Why? Well, assuming that long-dated US Treasuries benefit from flight-to-quality flows and that investors anticipate this safe-haven demand, BABgov returns should correlate positively with risky-asset returns. This means that BABgov returns should be lower during bearish markets. But BABgov returns are likely to depend on the severity of shocks. During mild shocks, investors tend to move up the credit spectrum but do not usually shift to bonds with shorter maturities. This investor reaction generates BABgov losses. However, during more severe shocks, when investors tend to move up the credit spectrum and shift to bonds with shorter maturities, BABgov returns should be positive. So, investors expecting the strategy to perform well in mild down markets may be disappointed.
Investors and investment professionals should only employ BABgov after careful consideration. They should make sure that they fully understand the likely impact of employing BABgov on their portfolio under various economic conditions before allocating to this strategy.