Safer stocks (“boring” ones) tend to be good investments on average and even more so in “boring” times. In a study published this year in the Journal of Financial Economics, a leading journal in Finance, co-authored by Andrew Detzel from Baylor University (USA), Paulo Maio from Hanken School of Economics (Finland) and myself, we document this pattern and test several explanations. The most convincing one in our tests points to the existence of perverse incentives in the fund management industry. This article summarizes the study’s findings.
One of the most thoroughly studied relationships in financial economics is that between risk and return. On average, riskier asset classes such as equities offer higher returns than bonds or time deposits with lower risk, as they should. However, the difference is small when comparing stocks with different levels of risk. This results in the so-called low-risk anomaly, whereby investments in more “boring” stocks yield returns that are too high for their level of risk. This pattern remains a mystery without any universally accepted explanation and has been intensely studied and debated for the past fifty years.
For context, in the stock market there are low-risk companies such as utilities (EDP, REN, for instance) or firms with highly stable sales (Unilever and Coca-Cola, for example). Others, such as TESLA, are much riskier. The most widely used measure of risk (the CAPM) is the beta, which captures how a company’s stock reacts to market fluctuations. For illustration, when the market falls 10%, TESLA tends to fall 20% on average, therefore having a beta of 2 (=20%/10%, the ratio). REN, by contrast, drops only 2%, having a beta of 0.2.
It would be reasonable to expect higher returns for higher risk. But is that what happens? Yes, to a certain extent. Over the past 60 years in the US, high-beta stocks have offered risk premia around 30% higher than those of low-beta ones (comparing the extreme deciles). However, they achieve those returns with nearly triple the risk (roughly 270%). This implies that a strategy consistently investing in “boring” stocks and shorting “risky” ones generates abnormally high returns of around 5% to 6% per year.
Several explanations have been proposed for the low-risk anomaly. To exploit it, a risk-tolerant investor should borrow money to invest in a leveraged portfolio of boring stocks. However, not all investors with such tolerance are willing to take on the bankruptcy risk that this entails. (In fact, some institutional investors are restricted in their ability to leverage by their regulators or even forbidden to do so.) Another possible explanation is that riskier stocks have greater upside potential. Their risk-return ratio may be weak, but they carry a “lottery ticket” appeal, capable of very high payoffs in an optimistic scenario, however unlikely that may be. Some investors may simply prefer this type of investment.
Our study, however, supports a different explanation. It rests on the idea that professional investors are typically rewarded for outperforming the market in terms of raw returns rather than risk-adjusted ones, as they ideally should be. They are also incentivized to attract capital into the funds they manage. One effective way of doing so is by buying high-risk stocks in anticipation of a strong market year. That is precisely when high-risk stocks perform best and when investors are most likely to pour more money into funds. This creates a dual incentive for institutional investors to prefer high-risk stocks, even though those stocks deliver poor returns for their level of risk.
In our study, we found that investing in boring stocks works best during periods of low volatility, “boring” times. This finding supports the distorted-incentives hypothesis among fund managers. In our tests, we confirmed that these managers tend to favor high-risk stocks. They also cut their positions substantially when volatility rises, to manage their market exposure. Conversely, they assume much more risk when volatility falls, selling boring stocks precisely when they become more attractive. In other words, professionals display rational behavior but under misguided incentives.
Our study suggests that some asset management firms should reconsider their incentive systems. However, that is not straightforward since these are rational responses to the behavior of retail investors in their funds. On the other hand, investors seeking to improve their portfolio efficiency may benefit from paying closer attention to this neglected quality of boring stocks in boring times. That is when they prevail, much like the tortoise in the fable.
Pedro Barroso, Professor at CATÓLICA-LISBON