Low Beta Investing: The Anomaly of Lower Risk And Greater Returns

Greater risk means greater rewards.  That’s the mantra we’ll taught about stock market investing.  Take the risk of investing in the stock market and you could lose money… but you might also make considerably more than you would in a bank account, or money market fund.

“Without risk there is no reward.”

That’s the story we’re told as newbie investors anyway… along with other good bedtime stories like the Capital Asset Pricing Model, and the Efficient Market Theory.

As we all know reality ends up a little different than our favorite bedtime stories would suggest.  The real world is more than just black and white, good and evil fighting away in epic battles where good eventually triumphs.  No, the real world is filled with plenty of grey area… and sometimes (but not always) greater risk does not mean greater return.

Yep, it’s time for a different kind of bed-time story…


Beta And Measuring Risk

In order to tell this frightful bedtime tale, I’m going to need to talk about Beta.

Wait, don’t get scared off!  Just because academics gave Beta a Greek letter, that doesn’t mean it’s something terribly hard to understand (like solving differential equations)!

Beta is how “risk is measured” in stocks, but it really just measures the relative volatility of a stock to the market as a whole.

  • A beta of less than one is less volatile (moves less) than the market as a whole (typically approximated by the S&P 500 index).
  • A beta of one is as volatile as the market as a whole (typically approximated by the S&P 500 index).
  • A beta of negative one moves opposite to the market as a whole.  When the market goes down, the negative beta stock goes up by an equal amount, and when the market goes up, the negative beta stock goes down by an equal amount.

The theory around beta is, if a stock has a higher beta then stock is volatile, and thus riskier than the market as a whole.  In a efficient market higher risk should lead to higher rewards.  At least his is the bedtime story of stock returns that economists and academics tell their kids at night.

It’s a great story, but does the real world actually work this way?

That’s the question that some Harvard Business School researchers investigated in 2013… and they found that higher beta stocks do not outperform low beta stocks.  They found that inefficiencies exist in the real world, and lower beta stocks actually outperformed higher beta stocks.  Depending upon the data set and the time period looked at, the out performance amounted to several percentage points annually.

You can read the Harvard Business School research paper here, if you’re into that kinda thing.  It’s pretty fascinating stuff if you care about how theory and the real world diverge.

Even if you don’t care about theory, you probably should care about the returns.  One or two percentage points of out-performance annually can make a big difference when compounded over a lifetime.

So is there anyone who’s actually tried it?  Has anyone tried out this “low beta” investing theory in the real world to see how it ultimately performs?

Turns, out someone’s been doing it for 40 years….


Buffett’s Alpha

A couple of months ago I stumbled upon a paper called Buffett’s Alpha in the Q4 Financial Analyst Journal.  In this particular paper, the researchers tried to understand why Warren Buffett has been able to outperform the market for 40 years.  After 4 decades, it clearly isn’t just luck…

So what has he been doing for the last 40 years that causes such out-performance?  You guessed it — low beta investing (according to the paper).  On top of that he uses the float from his insurance companies to leverage those investments.

The researchers found that Buffett’s investments consisted of stocks that were safe (i.e. low beta), cheap, and high quality.  Fascinating stuff, and definitely worth a read for those inclined.

Buffett himself has made mention of value investing (buying cheap stocks) and high quality stocks in the past.  All of that is a well-known part of his strategy… but never have I heard of beta mentioned by him as a deciding factor in stock selection.


Theories Why Low Beta Worked

The problem with academic papers is that they never give us the complete story.  Why does beta matter?  After all, stock volatility should in theory have very little to do with the risk of the actual business.  Stock volatility depends upon what shareholders are doing and what percentage of the float is traded on a regular basis.

So why did stocks with low beta’s outperform in the past?

I have a few theories as to why:

  • Low beta stocks could be associated with lower risk businesses.  In other words, stocks with more consistent earnings and thus higher stability.  That stability could cause positive actions on the part of management — such as more consistent share buybacks, or greater risk taking to expand the business.
  • Low beta stocks could be associated with boring stocks.  That is, stocks with very little news or industry change that might cause volatility on the part of investors.
  • A low beta stock could be a stock with low share turnover — implying a large number of shareholders don’t buy and sell very often OR the stock has a controlling shareholder (such as the company founder) that doesn’t trade those shares.



As you might expect, once someone thinks they’ve found “the secret” to out-performance, money rushes into that strategy essentially killing it.  The Harvard Business School paper I cited in this post was published in 2013.  Since that time, there’s been a slew of “low volatility” ETF’s launched to try to capture some of this “low risk – high reward” investing as described.  Names like:

  • Fidelity Low Volatility Factor ETF (FDLO)
  • iShares Edge MSCI Min Vol USA ETF (USMV)
  • iShares Edge MSCI Min Vol Global ETF (ACWV)
  • Invesco S&P 500 Low Volatility ETF (SPLV)
  • Invesco Russell 1000 Low Beta Eq Wt ETF (USLB)
  • Invesco S&P 500 High Div Low Vol ETF (SPHD)

Clearly this is a well capitalized idea.  But how’s the performance been since those funds launched?  Mixed.  Some of the low-beta funds have outperformed, and others have underperformed.  Clearly low-beta investing isn’t the easy home run that academic papers make it out to be.

More importantly, I think the Low Beta Anomaly reminds us of a very important investing principal — What worked well in the past won’t necessarily work well in the future.  When a good performing strategy is discovered via back-testing, the advantage tends to disappear as money rushes in to adopt the strategy, and killing the returns.

Clearly we know Low Beta used to work well — The data supports it.  But the new ETF return data points seem to indicated the advantage Buffett once enjoyed to outperform the market has mostly disappeared.  Well, maybe it still works… it seems to depend upon the particular ETF.

So, what’s an investing strategy that will bring out-performance in the future?  I haven’t the faintest clue!

[Image Credit: Flickr]

14 thoughts on “Low Beta Investing: The Anomaly of Lower Risk And Greater Returns

  • March 13, 2019 at 6:25 AM

    “Once someone thinks they’ve found “the secret” to outperformance, money rushes into that strategy essentially killing it.”

    This is the rub right? For me, when a stock looks too good to be true I look for validation. By the time that comes, its over. At the same time if I go alone and am wrong then it is a mistake. Ken Fisher talks alot about this and looking where no one else is and then being ahead of consensus. Of course he has a whole research team and I just have me and my computer and his results are mixed depending on the market cycle. Finding the low beta high alpha unicorn aint easy

    • March 14, 2019 at 9:14 AM

      Yes, finding unicorns is hard, but there are plenty of horses standing around in plain site. Don’t miss the obvious when searching for a unicorn!

  • March 13, 2019 at 11:22 AM

    Interesting idea, always thought beta is related to return.

    But like you said, if people have “found” the secret, money will rush in and kill the possible return. Time to find another investing secret. 🙂 😉

    • March 14, 2019 at 9:13 AM

      Yep, and it’s fun to blog about how these strategies don’t really work!

  • March 13, 2019 at 7:08 PM

    Hi – is this research one which finds a common attribute across a pool of high performing stocks and assumes that the attribute of low beta must be the cause of the outperformance? Is the logic something along the lines of all great NBA basketball players are tall men. So all tall men must be good basketball players? That logic doesn’t work.

    High performing stocks might have low beta and you have listed the reasons why. But does it mean all low beta stocks are high performers? I guess with the mixed return profiles of the low vol ETFs we have our answer.

    • March 14, 2019 at 9:12 AM

      Right! I actually believe that the chicken definitely comes before the egg (low beta) in this case. It’s all about the reasons why investors ‘sit still’ that *creates* the low beta.

      In the case of the Buffett’s Alpha paper, I actually believe they have it completely backwards. Buffett isn’t actually buying for low beta — it’s because he invests and then holds that *creates* low beta.

  • March 14, 2019 at 3:55 AM

    It might be interesting to investigate why some of the low beta ETFs outperformed while others underperformed. Was it due to selection criteria (beta threshold), turnover (or lack there of), number of holdings, or some other reason?

    • March 14, 2019 at 9:08 AM

      That might be interesting — seems like a perfect research project you could blog about! Feel free! 😉

  • March 14, 2019 at 8:43 AM

    I recently listened to an audio version of a book about Warren Buffet and Charlie Munger investing. While it talked about value and many other things, I thought it was interesting that they do not purchase a stock or company unless they believe they will probably achieve a 15% return. It also stated that even when they loan money to one of their own companies they do it at 15% interest. The problem with a lot of ETF index stocks is they just pick one or two things to focus on and usually have a lot of stocks. Buffet will also focus on does it have a “wide moat” and future earnings potential as well as other criteria I would guess. There is an entertaining youtube video of Charlie Monger talking about diversification is for the know nothing investor and you really only need to own about 3 stocks.

    • March 14, 2019 at 9:04 AM

      Yup, and he really believes it — Munger himself is known to invest in only three things: Berkshire, Costco, and the money he has invested with a Chinese hedge fund manager. That’s it. He walks the talk.

      What was the audiobook?

  • March 15, 2019 at 12:05 PM

    Rather than trying to guess what strategy will work in the future, I’ve long decided to just invest in ETFs like the S&P 500 and MSCI World. They might not give as high returns as if I was optimizing, but nothing else is as simple to manage and as freeing of time!

    • March 15, 2019 at 12:19 PM

      Are you implying that I’m trying to “guess what strategy will work in the future” here? This post isn’t about “guessing strategies”.

      You might try reading the post instead. I’ve always found reading to be a very enlightening activity and quite valuable.

      • March 15, 2019 at 12:26 PM

        I was talking about my own ETF investing strategy as opposed to chasing the latest theory as portrayed in your conclusion by the list of ETFs. I found your article well researched and insightful. It was interesting to learn of something that goes against the mainstream such as low risk, great return.

        We couldn’t agree more on your last point.

  • May 4, 2019 at 11:02 AM

    Hi Mr. Tako,

    Thank you for sharing the studies.

    From your ideas about why the low beta outperform the markets, I would give a higher weight on the first one. Such kind of companies could be considered as a safe shelter during market crises.

    I’m having some thoughts on it. The timeframe of the Buffet’s paper took into consideration 40 years (1976-2017), in which we had 6 bear markets. The ETF’s listed are considerable new, around 5 years, in which we are on a bull market. This could be on of the reasons why all of them are underperforming SP500 and even the category return. I’m curious to see how they will perform during the next bear market.

    I looked into the top 10 holdings for each mentioned ETF and there is not even one stock that appears in all the ETF’s. JNJ appears in 3, KO, PEP and V in 2.I do not know the criteria for selection on it, but we even have some curious choices like Zynga and Ford.

    All the best.



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