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The Case for Beta

By:

President And Chief Investment Officer

Beta is a quintessential part of the Capital Asset Pricing Model (“CAPM”), which is a model used to determine expected market returns. To accomplish this feat, it’s important that investors understand how certain stocks correlate with the overall market. To do this, we would want to measure a stock’s systematic risk, or “beta”, which is a mathematical computation to determine how much risk is being driven by market behavior as opposed to the news and fundamentals of the stock itself. Some individuals may look at a stock’s standard deviation of returns to determine its risk profile. However, Global Beta believes that is only part of the equation to determining a stock’s fundamental risk characteristics. When measuring a stock’s standard deviation of returns, Global Beta believes there are limitations to the interpretation of risk with regards to the price movements of the stock. A stock could have a higher standard deviation of returns; however, the volatility of those returns could indicate that those price movements are positive. To further understand the context of single stock price movement volatility, we believe it is important to add context, which is why we utilize beta to screen for companies’ risk profiles. In the case of U.S. equity stocks, we believe the S&P 500 Index generally serves as an appropriate benchmark for beta calculation. Now that we have identified a benchmark, we can proceed with a beta calculation, as formulated below:

  • Bp = beta of the stock
  • Cov = covariance of two investments, or the linear relationship between two investments
  • Var = variance of an investment, or its standard deviation of returns
  • Rp = return series of the stock
  • Rb = return series of the benchmark

What this formula measures is the relationship between the return of a stock versus a defined benchmark (in this case, the S&P 500 Index) versus the standard deviation in the returns of that benchmark. Therefore, beta is telling us how much the stock is deviating from the benchmark for every metric of return deviation in the benchmark. In other words, it is telling us how much the stock is moving relative to the benchmark. For example, if a stock had a beta of 2 relative to the S&P 500 Index, this would imply that the price of the stock will move twice as much (in either direction) as the S&P 500 Index.

(Beta: Beta measures the sensitivity of an investment to the movement of its benchmark. A beta higher than 1.0 indicates the investment has been more volatile than the benchmark and a beta of less than 1.0 indicates that the investment has been less volatile than the benchmark.)

In contrast, standard deviation simply measures the magnitude of price movement in a stock. This combines the systematic risk of the stock and the idiosyncratic risk of the stock, which is risk assigned specifically to the company, not its relationship with the rest of the market. We believe this is the inherent problem with looking at standard deviation to determine the risk profile of a stock. It cannot differentiate whether the stock is moving because of risk related to the stock itself or risk related to the market. Below is an illustration of the calculation of standard deviation:

  • α = standard deviation of the stock
  • ∑ = sum
  • xi = return for each period of the stock
  • µ = the average return of the stock for the period
  • n = number of periods

As the formula above illustrates, the calculation of standard deviation is the measurement of the ferocity to which the returns of the stock over the period move with respect to the average of the returns for the period. To put it simply, if a stock returned 9% over the past 12 months with a 15% annualized standard deviation, that would mean on average, the stock would have moved by an annualized rate of 15% in a given month over that period. On the surface, an investor may infer that as a lot of price movement to end up yielding 9% for the year. However, this evaluation lacks context in the risk that the market had overall, and thus, we do not believe properly defines the risk premium of the investment in that stock.

If you are thinking that a stock with a high standard deviation would likely have a higher beta, that’s not necessarily the case. These risk characteristics are distinctly nuanced. To provide a real-life example, let’s take a look at a pair of stocks held by the Global Beta Low Beta ETF (“GBLO”) versus the S&P 500 Low Volatility Index.

Let’s begin with a stock that is held by GBLO but not held by the S&P 500 Low Volatility Index, as of 03/31/21: Netflix (“NFLX”). Below is a chart that illustrates NFLX’s annualized standard deviation of return, annualized return, and beta, one year trailing from 02/26/21:

BFLX Standard deviation of return

As shown above, NFLX had an annualized standard deviation of 48.69% over the period, which would appear to be substantial price movement for any stock, and certainly would increase the risk profile for the stock.  However, despite the high standard deviation of return, the beta of the stock relative to the S&P 500 was just 0.68.  How is this possible?  What this tells us is that NFLX’s standard deviation of return was not much more risky compared to the market.  As we discussed above in the overview of the calculation of beta; the numerator, which is the covariance of returns between the stock and the benchmark, becomes a critical component here.  In this case, although NFLX’s standard deviation of return was high, the fluctuation of those returns had a low correlation to those of the S&P 500 Index, and thus, NFLX demonstrated a beta of just 0.68 to the S&P 500 Index.  In fact, NFLX outperformed the S&P 500 Index over that time, underscoring that its idiosyncratic risk was positive.  As a result, GBLO holds NFLX while the S&P 500 Low Volatility Index does not.

On the other side of the spectrum, let’s analyze a stock not held by GBLO but is held by the S&P 500 Low Volatility Index, as of 03/31/21:  the Coca-Cola Company (“KO”).  The next chart illustrates KO’s annualized standard deviation of return, annualized return, and beta, one year trailing from 02/26/21.

As shown, KO had an annualized standard deviation of 34.75%, which although is traditionally high, was just about in line with that of the S&P 500 Index and much lower than NFLX’s for the period.  Although KO’s standard deviation of return was much lower than that of NFLX, its beta relative to the S&P 500 Index was still higher at 0.81 compared with 0.68 for NFLX.  However, it turned out that the covariance of returns between KO and the S&P 500 Index was higher than that of NFLX and the S&P 500 Index, which resulted in NFLX having a lower beta than KO.  In this case, although KO’s standard deviation of return was lower than NFLX, the fluctuation of its returns had a higher correlation with the S&P 500 Index, thus, KO demonstrated a beta of 0.81 to the S&P 500.  In fact, KO actually underperformed the S&P 500 Index over the period, underscoring that its idiosyncratic risk was quite negative.  As a result, GBLO does not hold KO while the S&P 500 Low Volatility Index does.

KO annualized standard deviation

Global Beta believes that understanding how stocks relate to the market provides us with a better understanding of their true risk profile.  As a result, we believe this should curb investors’ downside risk during volatile times without entirely sacrificing the upside of the market.  However, Global Beta believes it’s important for investors to create a balanced portfolio through various factor exposures.

As always, Global Beta believes it is important to balance your factor exposure in your portfolio.  It is important that investors consider valuation within each segment of the market.  However, as we observe current macro trends, we believe investors may benefit from allocations to the above-mentioned factors.

Originally Posted on June 7, 2021 – The Case for Beta

The S&P 500® Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The index benchmarks low volatility or low variance strategies for the U.S. stock market. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.

The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 11.2 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 4.6 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.

Standard Deviation: Standard deviation of returns measures the average a return series deviates from its mean. It is often used as a measure of risk. When a fund has a high standard deviation, the predicted range of performance implies greater volatility.

Covariance: Covariance measures the directional relationship between the returns on two assets. A positive covariance means that asset returns move together while a negative covariance means they move inversely.

Correlation: A statistic that measures the degree to which two securities move in relation to each other.

Before investing you should carefully consider the Fund’s investment objectives, risks, charges, and expenses. This and other information is in the prospectus or summary prospectus. A copy may be obtained by visiting www.globalbetaetfs.com or calling (833) 933-2083. Please read the prospectus or summary prospectus carefully before investing. Past performance is no guarantee of future results.

Investors will incur usual and customary brokerage commissions when buying or selling shares of the exchange-traded funds (“ETFs”) in the secondary market, and that, if reflected, the brokerage commissions would reduce the performance returns. Current performance may be lower or higher than the performance data quoted. Shares are bought and sold at market price (not NAV) and are not individually redeemable from the fund.

Global Beta Rising Stars ETF (GBLO) Risks:

The fund’s primary risks:

Risk Considerations Investing involves risk including the possible loss of principal. There can be no guarantee that the Fund will achieve its investment objective. The Funds are subject to the principal investment risks noted below, any of which may adversely affect the Fund’s net asset value (“NAV”), trading price, yield, total return and ability to meet its investment objective.

Low Beta Risk. Although subject to the risks of common stocks, low volatility stocks are seen as having a lower risk profile than the overall markets. However, a portfolio comprised of low volatility stocks may not produce investment exposure that has lower variability to changes in such stocks’ price levels. Low volatility stocks are likely to underperform the broader market during periods of rapidly rising stock prices.

Non-diversified risk. The Fund is considered “non-diversified” and may be more susceptible to a single adverse economic or regulatory occurrence affecting one or more of these issuers, experience increased volatility and be highly invested in certain issuers than a diversified fund.

Factor Risk. The fund’s underlying index, and thus the Fund, seeks to achieve specific factor exposures. There can be no assurance that targeting specific factors will enhance the Fund’s performance over time, and targeting exposure to those factors may detract from performance in some market environments.

Concentration Risk To the extent that the Target Index is concentrated in a particular industry, group of industries or sector, the Fund is also expected to be concentrated in that industry, group of industries or sector, which may subject the Fund to a greater loss as a result of adverse economic, business or other developments affecting that industry, group of industries or sector.

Large Capitalization Securities Risk The securities of large market capitalization companies may underperform other segments of the market because such companies may be less responsive to competitive challenges and opportunities and may be unable to attain high growth rates during periods of economic expansion.

Index performance does not represent Global Beta Low Beta ETF performance. It is not possible to invest directly in an index.

Holdings are subject to change and should not be considered investment advice. Click here for a list of GBLO holdings

Distributor: Compass Distributors, LLC

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Global Beta Advisors and is being posted with permission from Global Beta Advisors. The views expressed in this material are solely those of the author and/or Global Beta Advisors and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

In accordance with EU regulation: The statements in this document shall not be considered as an objective or independent explanation of the matters. Please note that this document (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and (b) is not subject to any prohibition on dealing ahead of the dissemination or publication of investment research.

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