Leveraging Low-volatility Stock Portfolios

Can investors safely use leverage to squeeze incremental return from low-volatility/factor-tilted stocks, thereby avoiding underperformance of these stocks during bull markets? In their October 2024 paper entitled “Low-Risk Alpha Without Low Beta”, David Blitz, Clint Howard, Danny Huang and Maarten Jansen exploit the low-volatility anomaly by leveraging multifactor, low-risk, global stock portfolios to a beta of 1.0 while controlling tracking error relative to a capitalization-weighted benchmark. Their portfolio formation rules are:

• The portfolio is long only and fully invested in liquid (large-capitalization) stocks.
• Maximum individual stock weight is the lower of 1.5% or 20 times its benchmark weight.
• Exposure to countries, regions and sectors may deviate at most 10% from benchmark weights.
• Portfolio beta (portfolio-weighted sum of historical stock betas for the last 156 weekly returns) must be less than 0.8 relative to the benchmark.
• Portfolio optimization involves trading off expected returns, benchmark tracking error and turnover. Expected stock returns derive from a multifactor score with 50% for low-risk (equal-weighted combination of past 260-day volatility, 156-week volatility, 260-day beta and 156-week beta), 16.67% for value (net payout yield), 16.67% for quality (gross profits to assets) and 16.67% for momentum (return from 12 months ago to one month ago).
• Use synthetic positions (for example, via equity options) to achieve leverage, with no cash collateral and financing costs equal to the risk-free rate.
• Rebalance at the end of each month but ignore slight deviations from target weights.

They separately discuss impacts of portfolio rebalancing frictions and additional leverage costs/penalties. They focus on developed markets but also look at an emerging markets sample and North American, European and Asia Pacific subsamples. Using daily and monthly data for developed market stocks since December 1985 and emerging market stocks since December 1995, all through December 2023, along with contemporaneous spreads and interest/Treasury bill rates, they find that: (more…)