Spare a thought for poor old beta. Like an aging rock star, it seems the once-iconic metric can now only reminisce fondly about its halcyon days in the 1960s. Back then it bestrode the financial literature like a colossus. Countless grad school seminars pulsated to its mighty beat, with eager researchers crushed in like fans in a mosh pit, screaming for just one more encore on the portfolio applications of this gauge of systematic risk, clawing the Harris Tweed from their professors’ backs (note to readers, I wasn’t around in the 1960s, this last part may be an exaggeration).
Today, after years of questioning its empirical validity, beta doesn’t always get the attention it deserves. But the fact remains that, the Capital Asset Pricing Model (CAPM), of which beta is an integral part, is not a bad starting point for thinking about the exposure that a portfolio or security has to market moves. Take a look at the below table which clarifies the importance of thinking about portfolio returns in light of their beta.
Let’s suppose that:
— There are only two states of the world, a market that’s either up +10%, or down -10%.
— There are only two portfolios, with betas either of 1.2, or 0.8.
— That the returns these portfolios achieve are as indicated in the table.
We hope you agree that it’s hard to tell whether a fund has done well or not simply by comparing its performance to that of the market. You also have to know how much systematic risk it was exposed to before you can properly gauge. One can imagine the following hypothetical conversation:
Excited Portfolio Manager: “Great News! Your portfolio was up 11% last year!”
Sensible Investor: “What did the market do?”
Excited Portfolio Manager: “That’s the best part, the market was only up 10%, and we beat it by 1%.”
Sensible Investor: “This is all meaningless unless I know my portfolio’s beta.”
Excited Portfolio Manager: “It was 1.2”
Sensible Investor: “So I had 20% more systematic risk than the market in my portfolio, which implies, in a CAPM world, an expected return of 12%. But you eked out an 11% return which amounts to generating a negative alpha for me of -1% (hangs up phone)…”
That’s one way the conversation could go but, if you look at the table, we have highlighted a total of four scenarios which, it seems to us, are highly counterintuitive. The first has been addressed in the above dialog - a market beating performance that is actually poor. But the other three are as troublesome: an up market performance that is below the market return but is actually good (alpha generative), a down market performance that loses more but is also good (alpha generative), and a down market performance that loses less than the market but is bad (alpha destructive).
Perhaps it’s time for beta to don its skin tight leather pants, retune its guitar, and sing to a whole new generation.