This finding provides broad evidence that the relative flatness of the security market line is not isolated to the U.S. stock market but that it is a pervasive global phenomenon. Hence, this pattern of required returns is likely driven by a common economic cause.
The Intuition for the BAB AnomalyThe intuition behind the BAB anomaly is that there are leverage-constrained investors who, instead of applying leverage to obtain an expected return higher than the market’s expected return, overweight high-beta stocks and underweight low-beta stocks in their portfolios. Their actions lower future risk-adjusted returns on high-beta stocks and increase future risk-adjusted returns on low-beta stocks. Oliver Boguth and Mikhail Simutin contribute to the literature on the BAB anomaly with the study “Leverage Constraints and Asset Prices: Insights from Mutual Fund Risk Taking,” which appears in the February 2018 issue of the Journal of Financial Economics and can be found here. They studied the pricing implications of leverage constraints using a measure of revealed borrowing demand that relies on financial intermediaries unaffected by fluctuations in the lending market (mutual funds). Boguth and Simutin write:
These investors face borrowing restrictions established by the Investment Company Act of 1940 and often self-impose stringent zero-leverage constraints. As a result, supply-based measures such as the cost of borrowing do not directly apply to them (only a small percentage of mutual funds use leverage). Because leverage restrictions shut down the supply channel, fluctuations in the demand for borrowing of mutual funds reveal the tightness of leverage constraints.The authors “argue that the observable risk taken on by mutual funds reveals their demand for borrowing and hence the unobservable tightness of the constraint.” To estimate this risk, they “calculate the value-weighted average beta of the aggregate stock holdings of all actively managed equity funds.” Their data sample covers the period from 1981 through 2014. The following is a summary of their findings:
- The average beta of mutual funds correlates with existing measures of funding conditions, such as broker-dealer asset growth and stock and bond liquidity.
- Their measure of leverage constraint tightness (LCT) strongly and significantly predicts returns of the BAB factor, which is long levered low-beta stocks and short de-levered high-beta stocks.
- Growth firms have higher LCT exposures, as evidenced by the negative coefficient on book-to-market and the positive coefficient on asset growth. This is consistent with investors attempting to overcome their explicit leverage constraints by using the leverage embedded in growth options.
- Exposure to changes in LCT strongly and negatively predicts fund performance in the cross-section of returns and the magnitude of the effect is economically large.
- The decile of funds with the lowest LCT exposures generates monthly excess returns of 0.82%, while the highest decile earns just 0.31%. The difference, approximately 6% annually, is statistically significant at the 1% confidence level after controlling for standard risk factors. Furthermore, the effect is not confined to extreme deciles. Rather, fund returns decrease monotonically with LCT exposure.
- The negative relation between LCT loadings and future fund performance remains large in gross-of-fees returns. It is robust to controlling for fund characteristics and determinants of mutual fund performance from prior literature as well as to alternative estimation approaches.
- Following times of non- or weakly-binding constraints (low LCT), the future one-month BAB return is 0.71%. It is much larger, at 1.18%, after periods of tight leverage constraints. The relation is similar over horizons of up to 12 months.
The strong pattern in the time-series and cross-country variation of expected returns shows that while low-beta stocks outperform high-beta stocks on average, on a risk-adjusted basis, the outperformance is stronger when and where past liquidity funding constraints are high. It's also stronger when past market returns are high.These findings have important implications for investors. When past returns are high, the risks of owning high-beta stocks significantly increase. Investors in actively managed mutual funds should make sure they fully understand their fund’s time-varying level of exposure to market beta and know how it changes during periods of strong performance. Forewarned is forearmed.