Updated: Apr 21, 2021
The empirical paper “Betting against beta” by Frazzini and Pederson (2014) is based on the “Beta arbitrage” idea by Black (1972). Both seek to maximise returns (alpha) by building a portfolio with a tilt towards low-beta stocks and away from high-beta stocks irrespective of the market environment.
stocks with a Beta<1 considered safe (low idiosyncratic risk)eg: Walmart β= 0.48
stocks with a Beta>1 considered risky (high idiosyncratic risk) eg: Tesla β= 2.01
Historically high Beta stocks have underperformed while low beta stocks have outperformed expectations from asset pricing models.
BAB suggests a simple strategy:
Go long low beta stocks (and use leverage to make the beta ~1).
Go short high beta stocks (and reduce the net exposure to make the beta ~1).
A BAB portfolio can be built with preferably more than 10 stocks:
Step 1: Rank stocks according to their Betas (small to high)
Step 2: group into deciles
Step 3: put stocks in deciles 6-10 into high-beta portfolio, short
-put stocks in deciles 1-5 into low-beta portfolio, long
-weight each stock according to its beta ranking (highest beta stocks get highest
weight in high-beta portfolio, lowest beta stocks get highest weight in low-beta portfolio).
By shorting high Beta stocks
and levering low Beta stocks
we obtain a lower risk higher return portfolio -->
On the other hand, BAB's strategy high returns are
substantially reduced when we
account for trading costs -->
The BAB strategy has been successful in Warren Buffett’s Berkshire Hathaway portfolio due to:
-High cash available from insurance premiums (Geico)
-Favorable borrowing rates due to AAA rating and thus very low credit spreads and the insurance float which amounts to below-T-bill borrowing rates
Buffett style therefore means purchasing stocks with the following characteristics:
-low beta, low vol; large firms; value (high book-to-market); no momentum (=no trend chasing); BAB; Quality companies!
Ultimately giving Berkshire Hathaway
a high Sharpe ratio
compared to other US stocks-->
Buffett style and leverage could be replicated by hedge funds and some institutional investors. However, this appears to be inconclusive for retail investors due to high borrowing cost and transaction fees especially for shorting stock!
The best way to include BAB or a Buffett style strategy in your portfolio is to invest in some of the following stocks: