Cliff Asness: Investors’ Fear of Leverage Drives Low-Risk Effect

Behavioral finance helps explain why low-risk assets tend to perform better than they should compared to high-risk assets.


In his latest paper, Betting Against Correlation, Cliff Asness seeks to uncover the reasons for the so-called low-risk effect, or the tendency for low-risk assets to perform better than they should against those that are high-risk. He identifies fear of leverage as a big driver.

Referencing the paper in a February 12th blog post, Cliff Asness, founder of hedge fund AQR Capital Management, says there are many possibilities for the low-risk effect, including investors’ aversion to leverage and preference for lotteries. The theories come from behavioral finance research.

Asness says that investors should choose a portfolio based on tradeoffs between risk and return, and then consider using leverage. In reality, though, the use of debt to increase returns is complicated as aggressive investors might “simply fear leverage beyond what’s warranted,” and as result, seek assets that have potential for high reward instead. In other words, they load up on risk.

“Leverage aversion creates excess demand for high-risk assets, while low-risk assets are unloved,” writes Asness, who is a prolific researcher. In turn, riskier assets become overpriced, he says, while low-risk assets are underpriced and deliver higher than expected returns.

Asness co-founded AQR, which aims to develop rigorous research for its investment strategies, with David Kabiller, Robert Krail and John Liew.

Identifying leverage as a driver of the “low-risk effect” is helpful in so-called factor investing, which has become one of the fastest-growing categories in finance. Although there isn’t one standard definition for the strategy, factor funds are broadly based on a set of rules, programmed into an algorithm, that provide exposure to an investing characteristic such as “low volatility.”

Asness also explores lottery preferences for the reason the low-risk effect may persist, again offering a simple behavioral finance explanation.

“Investors are wooed by assets that can exhibit a large upside,” he writes. When investors fall in love with securities, such as those that could be big winners in the future, their prices are pushed up beyond what’s reasonable. In contrast to low-risk assets, the pushed up pricing of riskier assets will make returns less attractive.