Question

Describe what"betting against beta"strategy is?

How is this strategy related to the Capital Asset Pricing Model?

Set out and explain the determinants of its performance?

Answer 1

The concept behind bet against beta strategy is to find an asset with higher beta and take a short position in them and finding a stock with low beta and taking a long position in them. the basic idea behind this act is the assumption that high beta stocks are overpriced and the low beta stocks are underpriced.

Beta is a measure of risk that cannot be diversified. Which means non-diversifiable risk. The beta measures the volatility of the stock.

CAPM model calculates expected return on an asset or portfolio. This theory is based on the inefficiencies of the Capital asset pricing model.

this is a statistical arbitrage strategy with the prices of assets coming back to median price against risk. this median is SML.

The strategy comes into action like this, based on CAPM valuation all reasonable investors invest their fund in the portfolio which yields expected excess returns per unit risk. this expected excess return per unit risk is the Sharpe ratio. Now the investors can leverage according to their risk preferences (using More of risk free return according to individual needs). But many individual investors have a tendency to overweight their portfolio towards higher beta assets inorder to improve retuns.

This tendency of the individual investors towards higher beta assets indicates these assets requires lower risk adjusted return versus lower beta.

Asset Quality Review ARQ, has constructed market neutral betting against beta factor that's used too measure this strategy.

there is some constraints for using this strategy as the individual investors may not find this useful because this requires large amount of capital and access to low trading cost to be successful. Also the performance of the strategy suffers from commission and other trading expenses.