Is there an effective Betting Against Alpha (BAA) strategy analogous to the widely used Betting Against Beta (BAB) strategy? In his October 2017 paper entitled “Betting Against Alpha”, Alex Horenstein investigates relationships between stock 1-factor (market), 4-factor (market, size, book-to-market, momentum) alpha and 5-factor (profitability and investment instead of momentum) alphas and future stock returns. He specifies BAA as a portfolio that is long (short) the capitalization-weighted stocks with realized alphas lower (higher) than the median alpha, rebalanced annually. He further specifies Betting Against Alpha and Beta (BAAB) that: (1) first divides stocks into a group with market betas below the median beta and a group with betas above the median; and, (2) then forms a capitalization-weighted portfolio that is long low-beta stocks with alphas below the median alpha within the low-beta group, and short high-beta stocks with alphas above the median alpha within the high-beta group. Additionally, he scales the long and short sides of both portfolios by the inverse of weighted betas, such that average portfolio market betas are near one. In other words, he applies leverage to side of the portfolio with high (low) aggregate beta of less (more) than one. For robustness, he also tests 1-month, 6-month, 24-month and 48-month portfolio reformation intervals. Using monthly data for a broad sample of U.S. stocks during January 1968 (with the first five years used for initial alpha and beta values) through December 2015 and contemporaneous factor model alphas, he finds that:
- Realized 1-factor, 4-factor and 5-factor alphas relate negatively to future stock returns, future alphas and future Sharpe ratios, perhaps because investors persistently overbuy (underbuy) stocks with high (low) past alphas.
- On average, the BAA beta-balancing leverages are 1.67X on the long side and 0.63X on the short side.
- Comparing BAA and BAB performance:
- Monthly gross BAA (BAB) Sharpe ratio is 0.22 (0.26), compared to 0.11 for market, 0.07 for size, 0.12 for value, 0.16 for momentum, 0.11 for profitability and 0.17 for investment factors.
- Monthly gross 5-factor alpha for BAA (BAB) is about 1% (0.5%).
- The correlation of monthly returns between BAA and BAB is only 0.21. That between BAA (BAB) and the market is 0.61 (0.16).
- Combining BAA and BAB as specified boosts performance. Monthly gross BAAB Sharpe ratio is 0.30, with gross monthly 5-factor alpha about 1%. The correlation of monthly returns between BAAB and the market is 0.32.
- Among intervals tested, a portfolio reformation interval of 24 (48) months is optimal for BAAB (BAA), generating monthly gross Sharpe ratio 0.34 (0.25).
In summary, evidence indicates that investors may be able to exploit systematic reversion of stock 1-factor, 4-factor and 5-factor alphas, and amplify exploitation via systematic reversion of stock market betas.
Cautions regarding findings include:
- As noted, reported alphas and Sharpe ratios are gross, not net. Portfolio reformation frictions and shorting costs would reduce their values. Long holding intervals mitigate frictions, but not shorting costs. Moreover, shorting may be infeasible for some stocks as specified due to lack of shares to borrow.
- Data collection, data processing and portfolio maintenance burdens are beyond the reach of most investors, who would bear fees for delegating these tasks to a fund manager.
See also the conceptually related:
