Bachelor of Science (Honours) Finance and Accounting

New Era University College

BBBFN-3334
Investment & Portfolio Management
May 2023 Semester

Student Name Chin Kean Hoe, Tan Hong Yu

Student ID 2220402, 2250171
 1.0 Introduction

    AQR, Applied Quantitative Research is a global investment management firm

based in Greenwich, Connecticut, United States. It was founded by famed investor
Cliff Asness.
He employs a statistical arbitrage strategy in which he takes short positions on high-
beta stocks and long positions on low-beta stocks, which is called bet against Beta .

The Capital Asset Pricing Model is a set of predictions about the equilibrium expected
returns of risky assets. When using CAPM, we use Beta to explain the relationship
between systematic risk and expected return for assets .Systematic risk means the risk
that affects and also unpredictable for the whole market .It is also called market risk
premium. Next, In terms of Beta (β). Beta (β) measures the volatility of the market
risk premium of a security and measures an asset's sensitivity to market movements to
compare the whole market. Many investors are using beta to try to gauge how much
risk a stock is adding to a portfolio.
 2.0 Bet Against Beta

The meaning of Bet against Beta is a strategy that Proposed by Andrea Frazzini and
Lasse Heje Pedersen.This investment strategy basically describes building a portfolio
that is long against low-beta assets and short against high-beta assets.

According to the journal article, it has 5 Proposition evidence to prove it

1. Due to limited funds, investors will invest in high beta (risk) securities which
give a lower alpha (return). (Proposition 1)

2. Investment which is based on the strategy of BAB can produce significant

positive risk-adjusted returns. (Proposition 2)

3. The return of BAB factor will give a lower return due to tight funding constraints.
(Proposition 3)

4. Beta can be compressed when increasing the funding liquidity risk. (Proposition
4)

5. Investors will hold riskier assets when they are tight on funds.  .(Proposition 5)
 Proposition 1 Test (high beta is low alpha)
According to the Journal article, they have mentioned using Proposition 1 to test how
the required return varies in the cross-section of beta-sorted securities .

Due to limited funds, investors will invest in high beta (risk) securities which give a
lower alpha (return)

We use (Et(rt+1s) = rf +ψt+βtsλt ) to explain the evidence.

Where the Risk premium: (λt = Et(rt+1M) - rf -ψt ) .ψt means the average Lagrange
multiplier, is used to measure the tightness of funding constraints.And λt means
security's alpha with respect to the market.
In this equation, we can see that there is a negative relationship between the beta (βts)
and Alpha (αts ). The higher the beta, The lower the return. And the reason affect this
is because of ψt, the more constraints the fund, the investor more willing invest in
high beta asset cause they hope getting high return. So, A tighter portfolio constraints
(means a larger ψt) will flatten the security market line, as intercept will be increased
and risk premium will be decreased.
 Proposition 2

In this proposition 2 stated that Investment which is based on the strategy of BAB
long leveraged low-beta securities and short higher beta securities earns a positive
expected return on average.

The table below shows that BAB factors can bring an average positive excess return .

In  this Table, we can see that every portfolio of Excess return are the positive
amount, so it will prove that BAB can bring an average positive excess return .
 Proposition 3
In proposition 3, we need to sequence the time series against the predicted BAB
returns. When funding receives severe constraints then the required future BAB
premium will increase. Realised BAB returns become negative for the same period.
By funding constraint means that we utilise the TED spread as a proxy variable for
the funding condition. The following table will confirm this statement.

Based on the above report, we can find that with the lag of TED spread, the
contemporaneous change in the level of BAB return and TED spread are negative.
Therefore, when high TED spreads indicate higher funding constraints, the lower the
future returns of BAB. High TED spreads may indicate that banks are credit
constrained and are slowly tightening credit to other investors over time.
Therefore, to avoid negative returns due to funding constraints, use the BAB factor to
short assets with high BETA and long assets with low BETA.
 Proposition 4
Under testing proposition 4, this is a test of the volatility of TED spreads to represent
the volatility of margin requirements. In the following table we can learn the cross
sectional dispersion of Betas sorted by TED volatility, with panel A showing US
equities, panel B showing international equities, and panel C showing all asset classes
in the sample.
According to the table above, since the BAB factor is constructed using historical beta
and does not take into account the effect of TED spreads, high TED spread volatility
implies that the realised beta is compressed relative to the ex-ante estimate of beta
used in constructing the portfolio. Therefore, high TED spread volatility should
increase the conditional market sensitivity of the BAB factor. However, in fact when
credit constraints are more volatile (high TED spreads), the market beta of the BAB
factor rises. Based on the above statistics, it is clear that the alpha of the BAB factor
remains large even when we control for time-varying market exposures. Therefore,
we can use the volatile TED spread environment to hedge the BAB factor and the
BAB factor will continue to earn positive excess returns.
 Proposition 5
The following TABLE is intended to confirm the last prediction (Proposition 5), and
this study shows evidence that mutual funds and individual investors hold high beta
stocks (Panel A), while LBO firms and Berkshire Hathaway buy low beta stocks
(Panel B).

Mutual funds and individual investors prefer high beta debt papers because they
believe that these high beta debt papers provide higher returns. This demand for high-
beta stocks generates upward pressure on prices, leading to their overvaluation.
Conversely, low beta stocks may be seen as less exciting or with lower excess return
potential and may be undervalued and ignored by investors. As a result, LBO
companies and Berkshire Hathaway purchases capture excess returns by leveraging
short high-beta debt securities and long low-beta stocks.
 6.0 Conclusion
Conclusion, betting against beta is an investment strategy that challenges traditional
financial theory by arguing that low beta assets can generate superior risk-adjusted
returns. The strategy exploits the mispricing of low-beta stocks, which tend to
outperform high-beta stocks in the long run. While the strategy has its limitations, it
offers an alternative approach to portfolio construction that has the potential to
improve risk-adjusted returns for investors.

One thing to note in my opinion is that the BAB strategy, like any investment
strategy, carries risk and investors should thoroughly assess their risk tolerance and
conduct due diligence before implementing it.