Explaining The Demand For Higher Beta Stocks

The Capital Asset Pricing Model (CAPM) indicates returns should go up linearly as beta increases (in other words, risk and return are positively related). However, as I’ve previously discussed, the historical evidence demonstrates that, while the slope of the security market line is generally positive (higher-beta stocks provide higher returns than low-beta stocks), it is flatter than the CAPM suggests. Importantly, the quintile of stocks with the highest beta meaningfully underperform the stocks in the lowest-beta quintile in both U.S. and international markets. The highest-beta stocks provide the lowest returns while experiencing much higher volatility. This runs counter to economic theory, which predicts that higher expected risk is compensated with a higher expected return.

Susan E. K. Christoffersen and Mikhail Simutin contribute to the literature with their study, “On the Demand for High-Beta Stocks: Evidence from Mutual Funds,” which appears in the August 2017 issue of The Review of Financial Studies. They examined whether external benchmarking pressures from sponsors of defined contribution (DC) plans would lead mutual fund managers to alter their behavior when they know their place on the sponsor’s menu depends on outperforming a benchmark. Their main premise was that “managers with a larger portion of sponsor-controlled assets in their funds are more sensitive to the benchmarking criteria and therefore more apt to change their behavior to beat benchmarks.”

Are Defined Contribution Plans Sensitive to Tracking Error?

Christoffersen and Simutin also hypothesized that DC plan sponsors are sensitive to tracking error as well. Funds in DC plans that increase their exposure to higher-beta stocks would also increase their risk of tracking error (that is, having their performance excessively deviate from the benchmark). Thus, fund managers would act strategically so as to maintain a low variance around benchmark returns.

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