Scott Cederburg

Does It Pay to Bet Against Beta? On the Conditional Performance of the Beta Anomaly

Prior studies find that a strategy that buys high-beta stocks and sells low-beta stocks has a significantly negative unconditional capital asset pricing model (CAPM) alpha, such that it appears to pay to “bet against beta.” We show, however, that the conditional beta for the high-minus-low beta portfolio covaries negatively with the equity premium and positively with market volatility. As a result, the unconditional alpha is a downward-biased estimate of the true alpha. We model the conditional market risk for beta-sorted portfolios using instrumental variables methods and find that the conditional CAPM resolves the beta anomaly.

Mutual Fund Investor Behavior Across the Business Cycle

Mutual fund investor behavior changes across the business cycle. In economic expansions, investors strongly display the documented behaviors of chasing returns and searching for managerial skill. Expansion investors earn higher returns and alphas by pursuing this strategy, but this result is partially explained by the momentum effect. In contrast, recession investors do not chase returns and exhibit a weaker tendency to seek alpha. Even before controlling for momentum, no smart money effect exists in recessions. Instead of chasing performance, recession investors make investment decisions to change their exposure to aggregate risk factors. Investors tend to avoid funds with exposure to the market and book-to-market factors during recessions, while they show the opposite pattern in expansions.

Implications of Long-Run Risk for Asset Allocation Decisions

This paper proposes a structural approach to long-horizon asset allocation. In particular, the investor draws inferences about asset returns from a vector autoregression (VAR) with economic restrictions on the intercept, slope, and covariance matrix implied by the long-run risk model of Bansal and Yaron (2004). Comparing the optimal allocations of investors using the longrun risk VAR versus an unrestricted reduced-form VAR reveals stark differences in portfolio strategies. Long-run risk investors are quite conservative relative to reduced-form investors due to intertemporal hedging concerns. Despite the differing strategies, both investors achieve success in timing the market. The gains of the long-run risk investor appear to arise from his ability to avoid exposure to large negative events, while the reduced-form investor better capitalizes on periods of high average returns.

Pricing Intertemporal Risk when Investment Opportunities Are Unobservable

The Intertemporal Capital Asset Pricing Model (ICAPM) predicts that an unobservable factor capturing changes in expected market returns should be priced in the cross section. My Bayesian framework accounts for uncertainty in the intertemporal risk factor and gauges the effects of prior information about investment opportunities on model inferences. Whereas an uninformative-prior specification produces weak evidence that intertemporal risk is priced, incorporating prior information about market return predictability generates a large space of ex ante reasonable priors in which the estimated intertemporal risk factor is positively priced. Overall, the cross-sectional tests reject the CAPM and indicate support for the ICAPM.

Conditional Benchmarks and Predictors of Mutual Fund Performance

Recent studies link mutual fund performance to measures of active management, and this evidence often takes the form of large spreads in unconditional alphas for characteristic-sorted portfolios. Unconditional benchmarks can, however, produce misleading inferences on managerial skill for strategies that exhibit substantial turnover and unstable factor exposures. We propose an approach to performance attribution that accounts for predictable changes in portfolio style. Compared to existing methods, our benchmarks yield superior tracking performance and a more powerful statistical assessment of abnormal returns. We reevaluate six proxies for active management using our method and conclude that these measures are largely unrelated to managerial ability.

Understanding the Risk-Return Relation: The Aggregate Wealth Proxy Actually Matters

ABSTRACT The ICAPM implies that the market’s conditional expected return is proportional to its conditional variance and that the reward-to-risk ratio equals the representative investor’s coefficient of relative risk aversion. Prior studies examine this relation using the stock market to proxy for aggregate wealth and find mixed results. We show, however, that stock-based tests suffer from low power and lead to biased estimates of the risk-return tradeoff when stocks are an imperfect market proxy. Tests designed to mitigate this bias by incorporating a more comprehensive measure of aggregate wealth produce large, positive estimates of the risk-aversion coefficient around seven to nine. Supplementary materials for this article are available online.

Conditional Benchmarks and the Identification of Skill in Active Management

Recent studies link mutual fund performance to measures of active management, and this evidence often takes the form of large spreads in unconditional alphas for characteristic-sorted portfolios. Unconditional benchmarks can, however, produce misleading inferences on managerial skill for strategies that exhibit substantial turnover and unstable factor exposures. We propose a performance attribution model that accounts for predictable changes in portfolio style. Compared to existing methods, our benchmarks yield superior tracking performance and a more powerful statistical assessment of abnormal returns. We reevaluate six active management proxies using our method and conclude that these measures are largely unrelated to managerial ability.