Low Risk Stocks Should Have Higher Risk-adjusted Returns than the Market

  • Leveraged constrained investors with high risk tolerance will invest more heavily in stocks that are riskier than the market
  • Investors with a lower risk tolerance than the market can deleverage very cheaply by holding some combination of cash and TSM
  • There is no reason for an investor seeking less risk than the market to invest in low beta stocks because they could instead just deleverage a portfolio with beta = 1.
  • The only reason for someone to hold low beta stocks is if they offer better risk adjusted returns than the market
  • If high beta stocks get bid up by leveraged constrained investors, then their risk adjusted returns will be worse than the market, consequentially low beta stocks must then have higher risk adjusted returns than the market
  • If low beta stocks do have higher risk adjusted returns, there are limits to arbitrage because leverage is not free
  • Low beta stocks should still underperform high beta stocks in absolute terms

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