Baker et al. (2011): Why Index Funds Promote High-Risk Stocks

#The Paper at a Glance

Title: Benchmarks as limits to arbitrage: Understanding the low-volatility anomaly

Authors: Malcolm Baker, Brendan Bradley, and Jeffrey Wurgler

Published: Financial Analysts Journal, 2011

DOI: 10.2469/faj.v67.n1.4

Why does the low volatility anomaly—where safe stocks beat risky stocks—persist? If it's so obvious, why don't hedge funds and mutual funds arbitrage it away?

Baker, Bradley, and Wurgler argue the culprit is benchmarking. The very mechanism designed to monitor fund managers forces them to make suboptimal decisions.

#The Benchmarking Trap

The Fund Manager's Dilemma

Imagine you manage a mutual fund measured against the S&P 500. - Scenario A: You buy boring, low-volatility utilities. The market roars up 20%. You're up 10%. You get fired for underperformance. - Scenario B: You buy high-flying tech stocks. The market drops 20%. You drop 25%. You keep your job because "everyone lost money."

To keep their jobs, managers minimize tracking error—the deviation from the benchmark.

High Beta Required

To keep up with a bull market, managers must hold high-beta (volatile) stocks. If they don't, and the market rallies, they will trail the benchmark.

This creates mechanical demand for high-volatility stocks. Institutions aren't buying them because they think they're good investments; they're buying them to protect their careers.

#The Mathematical Proof

The authors show that as long as the average investor is benchmarked, high-beta stocks must be overpriced.

1. 1Demand Shock: Benchmarked investors bid up high-beta stocks to reduce tracking error.
2. 2Overvaluation: Prices rise above fundamental value.
3. 3Low Future Returns: High prices lead to lower future returns.
4. 4No Correction: Rational arbitrageurs (who could short high-beta stocks) don't have enough capital to fight the massive wave of institutional money.

Result: A permanent structural anomaly where high-risk stocks deliver low returns.

#Evidence from Mutual Funds

The authors analyzed detailed holdings of active mutual funds: - Funds tend to overweight high-beta stocks (relative to what an unconstrained optimizer would choose) - The more "active" a fund claims to be, the more it tends to load up on volatility - This behavior is strongest when funds have experienced recent outflows (career risk is high)

#How This Applies to Our Rankings

This paper explains why our Low Volatility factor (10% weight) works and will continue to work.

The anomaly isn't a mistake that will be "fixed" by the market. It's a structural byproduct of the asset management industry. As long as fund managers are terrified of underperforming the S&P 500 in the short term, they will overpay for volatile stocks.

We are unconstrained. We don't care about tracking error. This allows us to systematically overweight the safe, boring stocks that institutions are forced to ignore.

See our low volatility rankings →

#Academic Source

Baker, M., Bradley, B., & Wurgler, J. (2011). "Benchmarks as limits to arbitrage: Understanding the low-volatility anomaly." Financial Analysts Journal, 67(1), 40-54.