would rise over the next year by an average of 17%. Jylhä also found the Fed raised the margin after a steady run-up in stock prices and lowered the margin after a steady drop. Congress had given the Fed responsibility for managing leverage available to investors and smoothing the ups and downs in stocks, and the Fed was doing its job.
Jylhä then went on to see if a change in margin also changed important elements of the market or the economy, elements that might also change the performance of low or high beta stocks. Changes in margin had no impact on market returns, trading activity, inflation, the money supply, or industrial production. That lined up nicely with comments from Fed chairs and press reports about the time of policy changes that the market and economy took the changes in stride.
Finally, Jylhä turned to a direct test of Frazzini and Pedersen. Betting-against-beta would predict that rising margin would steadily raise the returns on low beta assets and lower the returns on high beta assets, flattening the capital markets line. Jylhä found a striking result. At high levels of required margin, expected returns from low to high beta not only ran flat, they actually fell. When the ability to borrow vanished, expected returns in high beta stocks fell well below the likely outcomes in low beta stocks. As Frazzini and Pedersen had predicted, CAPM had unraveled.
Limits on More Than Leverage
The line of thinking first kindled by Fisher Black and fueled by Andrea Frazzini and Lasse Pedersen leads directly to considering all limits that shape investor behavior and asset value. Differences in access to leverage, for instance, create incentive for some investors to hold assets that inefficiently deliver risk and return. Those constrained investors reach for high beta stocks, and pricing of high beta stocks becomes dominated by inefficient capital flows. Limited leverage is not the only investor constraint, however. The cost of funds, the ability to hedge or offset risk, the quality of information, tax law, accounting rules, and legal and political constraints have heavy influence on individual and institutional portfolios. To the extent that constraints divide investors and their capital into groups and groups dominate different parts of the investment market, constraints shape asset value. Asset value changes systematically not just with the broad influences captured by market beta but also with the changing constraints on groups of investors.
In a market with constrained investors, each investor has to find a portfolio that efficiently considers the risk and return of the broad market, the current and future constraints the investor faces, and the current and future constraints of other investors. These all are risks that investors cannot diversify away and that require compensation. Robert Merton (1973a) long ago sketched the outlines of a market where investors considered not just the market basket of investments but also their ability to actually use the returns from their investment portfolios or reinvest those returns. Managing an efficient portfolio requires looking out into possible future investment opportunities and the constraints that shape both the investor and competing portfolios. That is the direction where theory goes next.
Note
1 1 The return on a betting-against-beta or BAB portfolio is where .
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