Fortune favours the brave? Not in markets

Contrary to the axiom of financial theory that investors are rewarded for bearing risk (as measured by beta), it appears that, in UK retail investment at least, low-risk funds have actually outperformed riskier peers over time.

So what is this anomaly, I hear you ask? Is it persistent? And the key question – does it imply that fund managers should focus on risk management rather than outperforming the benchmark?

To test the theory, I decided to plot the performance of all 270 funds in the Investment Association (IA) UK All Companies sector against their beta relative to the FTSE All-Share index.

Contrary to traditional financial theory, the graph showed a negative relationship between beta and returns over a 10-year period. This trend is stronger still when looking at two- and five-year periods.

When you look at the performance of the underlying funds and break down the IA UK All Companies sector every year by decile, ranked by beta – you have a clear indication that over the past five years an investor putting money into the lowest-beta funds would have significantly outperformed both their peers and their benchmark.

One should not be surprised by this result, as growth has strongly outperformed value in recent times.

The outperformance of low-beta stocks does not entirely explain why low-beta UK equity managers typically outperform

Last year’s stellar performances from the likes of Imperial Brands, SABMiller, Reckitt and BT help highlight how low-beta stocks can actually generate strong returns and outperform the wider market.

Nor is the low-beta anomaly a phenomenon that has arrived recently as a result of this era of loose monetary policy. It was first observed as early as 1970, and empirical evidence has been accumulating since then.

There are three popular theories to explain its existence. The first states that investors who demand high returns are leverage constrained and choose to increase their expected return by over allocating to high-beta stocks and under allocating to low-beta stocks.

A second stems from behavioural finance. Investors irrationally use high-volatility stocks as lotteries; in this framework, they are implicitly willing to accept lower expected returns by paying a premium to gamble with high-volatility stocks.

Another plausible behavioural theory attributes the anomaly to analysts’ optimism about more volatile stocks. Equity analysts tend to produce high-growth forecasts for high-volatility stocks; this can push up their prices and correspondingly reduce future returns.

Nevertheless, the outperformance of low-beta stocks does not entirely explain why low-beta UK equity managers typically outperform.

Portfolio construction has an equal role to play, as the average return of a portfolio is not simply the average sum of the constituents. Portfolio-level effects, such as rebalancing and compounding, must also be taken into consideration.

Dividends, for example, contribute a substantial part of the outperformance of the low-beta strategy. It makes sense as low-beta “boring” stocks must compensate by offering larger dividends; maturing businesses with high visibility in earnings pay dividends whereas growing firms do not.

Charles Younes is research manager at FE