There are a lot of new mutual funds and ETF’s available that call themselves “Smart Beta”. I want to write about Smart Beta funds, but then I thought I need to write about Beta before writing about Smart Beta.
Beta is a measure of an individual security’s volatility relative to the market as a whole. Mathematically, Beta is equal to the Covariance of the return of Asset A with the return of the benchmark, divided by the Variance of the return of the benchmark. That means, in order to calculate Beta, one needs the past actual returns of the specific stock and the returns of the appropriate benchmark over a relatively long period of time. Beta is usually stated as a number between -1 and +2. If a stock has a Beta of +1, that means its Volatility is equal to that of the benchmark. The most-often used benchmark is the S&P 500 Index. Beta of 0.5 means the stock is 1/2 as volatile as the benchmark; 1.5 means one and one-half times as volatile as the benchmark. A negative Beta means that the stock is inversely correlated with the benchmark.
Risk is a cousin of Volatility. In Finance, Risk is whether actual returns are consistent with projected returns. There are two types of Risk: Systematic and Idiosyncratic. Systematic Risk is Market Risk, and is measured by Beta. Systematic Risk is the risk that the entire benchmark faces, and is considered to be non-diversifiable. Idiosyncratic, or company or asset-specific risk, is risk that is unique to a specific company or industry. A skilled investment manager can diversify Idiosyncratic risk. Jim Cramer of “Mad Money” on CNBC runs a segment titled “Am I Diversified?”, wherein callers give Cramer their 5 largest individual stock holdings and ask Cramer if they are truly diversified. If Cramer deems that they are effectively diversified, he means that the portfolio will not significantly suffer if one stock falls while the others continue to meet expectations. They are diversified with respect to Idiosyncratic Risk only; not Systemic Risk. If the entire Benchmark Index plunges, the 5-stock portfolio will also likely plunge along with the Benchmark. The portfolio is not diversified from Systemic or Market risk, which is measured by Beta. Total Risk, which is Systematic plus Idiosyncratic Risk, is also called Variability, and is measured by Standard Deviation. The Sharpe Ratio uses Standard Deviation in the denominator of its equation and is therefore called the “Reward To Variability Ratio”. The Treynor Ratio uses Beta in the denominator (same numerator as Sharpe Ratio) and is called the “Reward To Volatility Ratio”. They are topics of future blog posts.
High or Low Beta?
In general, stable companies such as consumer products companies or utilities will have a low Beta (but likely will pay a relatively larger dividend), whereas high-tech and/or growth companies, or companies that are largely influenced by the news of the day will usually have a higher Beta, typically greater than +1 (and a smaller or no dividend). ETF’s or mutual funds usually do not publish a Beta – because they are already “the Market”. That does not mean ETF’s don’t have risk – it means that their risk is not measured or expressed by a Beta coefficient.
Beta is an academic, theoretical computation based on past performance. Past performance and future results may diverge. Companies change, investors’ perceptions of companies evolve, and so companies’ stock performance changes over time. The general message of a company’s Beta is useful; i.e., a Beta greater than 1 probably means the company’s stock is going to be volatile. If you are an investor who is looking for slow, steady returns and maybe a dividend, you should look toward low-Beta stocks. Or, you could look to a “Smart-Beta” ETF or mutual fund, which are gaining in popularity and which will be the topic of my next blog post.