The Low-Risk Anomaly: A Decomposition into Micro and Macro Effects

Low-risk stocks have offered a combination of relatively low risk and high returns. We decomposed the low-risk anomaly into micro and macro components. The micro component comes from the selection of low-beta stocks. The macro component comes from the selection of low-beta countries or industries. Both parts contribute to the anomaly, with important implications for the construction of managed-volatility portfolios.On a risk-adjusted basis, low-beta stocks have outperformed high-beta stocks in the United States and around the world. We decomposed this very basic market inefficiency into two components—a “micro” component and a “macro” component. The micro component arises from the selection of lower-risk stocks, holding country and industry risk constant. The macro component arises from the selection of lower-risk industries and countries, holding stock-level risk constant.For our industry decomposition, we used data from the Center for Research in Securities Prices (CRSP) for all US shares for the period January 1963 through December 2012. For our country decomposition, we used data from the S&P Developed Broad Market Index (BMI) of stocks for the period July 1989 through December 2012.The pattern of realizing low risk but earning high returns, the so-called low-risk anomaly, can in principle come from either the macro selection of lower-risk countries and industries or the micro selection of low-risk stocks within those countries and industries. We separated the two effects by forming long–short portfolios of stocks and held constant ex ante country- or industry-level risk to examine stock selection. Next, we held constant ex ante stock-level risk and examined country and industry selection. We found that both micro and macro selection contribute to the low-risk anomaly, but for two surprisingly different reasons.Whereas stock selection, within industries and countries, leads to higher CAPM (capital asset pricing model) alpha through a combination of significant risk reduction and modest return improvements, country selection leads to higher CAPM alpha through a combination of significant return improvements and modest risk reduction. In comparison to the stock selection effect and the country selection effect, the industry selection effect is relatively modest, and its associated CAPM alpha cannot be statistically distinguished from zero.These results suggest that when holding constant country- or industry-level risk, there is ample opportunity to form lower-risk portfolios through stock selection and that these lower-risk portfolios do not suffer lower returns. High-risk stocks can be distinctly identified within the utility industry or in Japan, for example, but they have similar raw returns on average when compared with low-risk stocks in the same industry or country grouping. This evidence supports the notion of limits to micro arbitrage in low-risk stocks that come from limits to leverage and traditional, long-only, fixed-benchmark mandates. The macro selection of countries in particular leads to increases in return, with only modest differences in risk. Countries that we identified as high risk ex ante were only modestly higher risk going forward, but they had distinctly lower returns. This evidence supports the limits to macro arbitrage across countries and industries.Our results on the decomposition of the low-risk anomaly into micro and macro effects have investment implications for plan sponsors and individuals alike. For individuals, they suggest that trying to exploit mispricing through industry, sector, or exchange-traded funds will capture only a portion of the anomaly. Although such a strategy can gain exposure to the macro effects, it cannot exploit the considerable risk reduction available in micro stock selection. For institutional investors and plan sponsors, our results suggest that perfunctory approaches to risk modeling and overly constrained mandates will not fully appreciate the benefits of the macro effects. Broad mandates with less stringent constraints and thoughtful techniques to modeling risk will do the most to exploit the low-risk anomaly.Authors’ note: The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research or Acadian Asset Management. The views should not be considered investment advice and do not constitute or form part of any offer to issue or sell, or any solicitation of any offer to subscribe or to purchase, shares, units or other interests in any particular investments.