Beta arbitrage as an alpha opportunity
Feb 5th, 2007 | Filed under: CAPM / Alpha TheoryBy: Tuomo Vuolteenaho, Arrowstreet Capital
Published: January 2006
Dresdner Kleinwort economist James Montier refered to this article in a recent piece. As Montier pointed out, Vuolteenaho argues that low beta stocks outperform higher beta stocks on a risk-adjusted basis (according to Montier’s own research, they may even outperform on an absolute basis). Vuolteenaho makes the logical step from this conclusion to the construction of a beta-neutral portfolio consisting of long positions in low beta names and short positions in high beta names. If this portfolio has a positive gross return, then “CAPM is C.R.A.P.” (to use Montier’s technical jargon). As this chart copied from the report shows, the CAPM seems especially stinky recently (the “late sample” = 1963-2001 while the “early sample” = 1927-1963).
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[…] Hat tip to the CXO Advisory blog for bringing this recent paper to our attention. It’s an interesting addendum to our posting on beta arbitrage last month. As you may recall, Tuomo Vuolteenaho, a Harvard prof moonlighting at ArrowStreet in Boston said that high beta stocks didn’t actually provide the higher returns that CAPM would suggest. As a result, he said, an investor should short high beta stocks and go long low beta stocks. […]
[…] High Leverage: Despite the fun stories from the LTCM or Amaranth debacles, hedge funds employ between 1.2 and 1.5 times leverage according to research cited by Easterling. If you’re searching for leverage, though, look no further than a typical high beta growth fund which has a lot of leverage - embedded in the balance sheets of the funds holdings as opposed to the books of the mutual fund itself. (Ironically, recent research on the CAPM shows that levering up a low beta stock is better than actually buying a high beta name outright). […]