2010: Fourth
Third Quarter
2012:
A DISCUSSION OF BETA – ITS LIMITATIONS AND USEFULNESS
by Anish Ramachandran, CFA
It’s been said that two things that you
never
want
made are
laws
“May
youtoliveseeinbeing
interesting
times.”
and sausages. Luckily for the squeamish,
Often thought
be a as
curse,
all to
portfolios
aren’t to
nearly
messy
of
us
have
lived
through
some
make. The way that we make them here
interesting
timesis-towecombine
are
atpretty
Ken Stern
& Associates
living
through
a
dynamic,
parts of our Core Fixed Income, Core
exciting,
changing
Equity,
Tactical
and environment.
Uncorrelated /
With
that
change
comes
Alternative sub-portfolios instress
just the
and weightings.
a concern for
thepart
future
right
Thewhat
tricky
is in
holds.
Although
this
is
a
natural
determining what those weights should
reaction,
thereisisdifferent
also the– they have
be.
Every client
possibility
that
such
different objectives, uncertainty
different time
can create
andrisk
thattolerances
we, as –
horizons
andvalue
different
investors,
can
capitalize
on
which means that every portfoliothis
needs
touncertainty.
be different,When
as well.pondering
The way that
changes
what
the future
they
are alland
similar,
though,
is in the way
holds,
a simple
that
oneIofaskthemyself
primary
considerations
– What do
think a is in
isquestion
putting together
any Iportfolio
billionaire
do?of that portfolio
managing
thewould
exposure
to the ups and downs of the equity
Ten years
the collective
markets.
Byago,
working
from the four
market
capitalization
ofabove,
all thewe at
building blocks mentioned
KS&A attempt to manage that market
exposure, which is referred to by the
Greek letter “Beta.”
There is probably no concept in equity
Pageand
valuation that is more abused
misinterpreted
than
beta.a The main
What do you
Think
reason
for
the
abuse
is
Billionaire Wouldbecause
do? beta has
become synonymous with the Capital
AssetTax-Free
Pricing Wealth
Model (CAPM),
which
and
states that the expected return of an
Other Year-End
asset is equal to a risk-free rate plus
Opportunities
the beta
of the asset, multiplied by the
expected market return, less the risk
free rate. Complicated, right? Really,
1
2
it’s simpler than it sounds – it basically
comes
down in
to the
the idea
that assets
companies
Standard
& with
betas
willwas
go up more than
Poor’sabove
500 one
Index
the
market
when
the
market
up
approximately $12 trillion.is going
Today
and
come at
down
more $10
thantrillion.
the market
it hovers
roughly
when
it’s
coming
down.
Assets
with
This contraction of market
betas
below oneover
will go
up less than an
capitalization
a ten-year
up
market
and
come
down
less than a
period is not common. During
down
market.we have experienced
that period
management tool. What I intend to do
in this article is to briefly discuss some
opportunities
that those challenges
of CAPM and beta’s shortfalls and then
created.
show how, despite its shortcomings,
we at KS&A use beta in portfolio
Two
years ago,
could
management
and Ihow
you not
can, have
too.
written about electronic books or
Criticismstablets
of Beta
electronic
that surf the web.
IOnce
could
not
have
written
of the major criticismsabout
of beta is
genetically
engineered
fish or even
the way in which
it is calculated.
This
high and prolonged
advanced
green
industries.
Next
technique is called regression, where
unemployment, currency crises,
year,
I assume
I’ll be able
the returns
of that
a particular
assettoare
There is probably no concept
wars, terrorism, health pandemics
meet
with
my
clients
via
compared to market returns over a
equity of
valuation
that isand videoconferencing
andin
a myriad
other worldon my
specified period of time.
Thetablet
problem
economy-shaping
events.
In
each
computer.
Who
could
have
with this is that there is little uniformity
more abused and
of the last ten speeches I have
imagined
five years
ago?is. Most
as to what that
that period
of time
misinterpreted
thana beta.
given,
I asked everyone
simple
Growth
and
innovation
stop,
practitioners suggest using never
5 years
of
question – What is going on in the they
simply
Thiswho
monthly
data,ebb
but and
thereflow.
are some
world today? Over 95% of the
rapid,
exciting,
andperiods
changing
period
think shorter
time
should
be
Unfortunately,
finance
literature
is filled must
responses were
negative.
Nobody
a positive.
If we
used. be
Theseen
betaas estimate
using
these
with
studies that
the inadequacies
commented
ondetail
the low
interest
want
to capitalize
change,and
we can
approaches
can be on
different,
if
of
CAPM
a predictor
of expected ask
rates,
low as
inflation
and potential
a then
beta ourselves,
is used as “What
a proxywould
for risk,
return.
In had
addition,
many well- billionaire
deals to be
in various
dothe
with
this one could
depending on
approach,
known
investors
and Nobody
professorstalked
like information?”
investment
sectors.
Or, perhaps
a better
get different results
regarding
the
Seth
Klarman
and
Stephen
Penman,
about the products from what I call question
when
with similar
market riskis,of
that faced
investment.
There
respectively,
have been that
very open in challenges/opportunities
“Happy Companies,”
What
did
are good reasons for using or- not
using
their
criticism
of
beta
and
CAPM
and,
consumers still love to buy,
really
smart
people dobut
during
particular
approaches,
sometimes
as
a result,or
many
think that if
recession
not.people
No one
challenging
to make
their
this confusionperiods
is enough
for investors
the
concept
is
not
good
enough
for
the
commented on the growing
fortunes?
What
we learn
from
to abandon the
usecan
of beta
in valuation.
pros,
it’s notand
good
enough for them. how they built and retained their
population
commensurate
The second criticism, which I believe to
Granted,
CAPM does No
make
some empires?
growing the
consumption.
one
be more relevant and the main reason
unrealistic
assumptions
– no transaction
even mentioned
the pace
of
why I personally take the beta quoted
costs,
all assets
beingindustries
tradable or
and Consider John D. Rockefeller,
innovation,
the new
on sites like Yahoo and Morningstar
everyone
having of
access
the same Andrew Carnegie and even Henry
the proliferation
new businesses
with a grain of salt is something called
information,
which leads
to everything Ford. Rockefeller started Standard
that have resulted.
Almost
“standard error.” It’s a complicated way
being
fairly priced
at all times.that
However,
universally,
the attendees
I
Oil.
He saw a new industry and the
of saying that the way we measure beta is
just
because
CAPM
makes
these
asked saw challenges, but not the
need
for synergy and consolidation.
imprecise and that it is so imprecise, that
absurd assumptions, it doesn’t entirely
negate the value of beta as a portfolio
we can even measure that imprecision!
(continued on next page)
2012:
2010: Fourth
Third Quarter
Page 2
For
example,
if a that
regression
It has
been said
he wasproduces
able to
abuild
beta estimate
of
1.5
with
standard
Standard Oil into a anearerror
of 0.2,bythen
we for
can efficiency
say with
monopoly
striving
95%
confidence
that
the
true
beta of
within his own model.
that asset will be between 1.1 and 1.9
(two
standard
errors).
Therefore,his
it is
Andrew
Carnegie
mortgaged
incorrect
assume
that aa stock
mother’stohouse
during
periodwith
of
beta
of
1.5
will
move
1.5
times
the
economic turmoil. He made a
movement
in the market
it’s 10
more
gutsy investment
of $500– for
accurate
to
say
that
there’s
a
95%
chance
shares of the Adams Express
that
that asset
between
1.1
Company
andwill
thatmove
bet paid
off well
and 1.9 times the movement of the
enough that he was given the
market. To complicate this, every beta
opportunity to make other gutsy
regression produces a different standard
moves – from steel to railroads. I
error, so one could see Stock A with a
believe he had an ability to search
beta of 1.5 and a standard error of .05
and Stock B with a beta of 1.5 and a
standard error of .3. Obviously, the
beta of Stock A is a much more precise
estimate,
but, unless
standardoferror
The following
is a the
collection
a
of
theofbeta
reported tothat
you, Iyou
would
few
theis strategies
believe
never
the difference
in precision.
couldknow
potentially
help our
readers
In
true beta
falls with
toaddition,
preservesince
andthe
protect
their
alegacies.
range, using
one estimate
Nojust
single
strategytoisassess
risk
could lead
errors
in making
appropriate
fortoevery
reader
investment
decisions.
though, so be sure to consider, with
yourfinal
advisors,
whether
The
knock against
betathese
comes from
strategies
are
appropriate
forlooking
you.
the fact that they are backward
and don’t capture the risk characteristics
of a company that is different today,
or in the future, from what it was in
the past. If the company’s profile has
changed, then the risk implied in today’s
price
willI think
be different
from past prices
When
of billionaires,
and
using
past
prices
to estimate beta
vultures come to mind.
could lead to errors in valuation.
Many of us tend to be emotional
Alternative Approaches
investors - on the days when the
Given
criticisms,
it should
come
marketthese
is higher,
we are
happier
as
no
surprise
that
many
people
and feel quite smug with our have
tried
to come On
up days
with when
alternatives.
investments.
the
Shannon
Pratt’s
Cost
of
Capital
details
market is lower, we second-guess
the
many ways
people have
tried to
ourselves
and wonder
why we’re
improve
upon
beta.
I
must
say
that,
not making any money. It’s hard
after
reviewing
alternatives,
not to
be on anvarious
emotional
roller I
was
more
confused,
since
most
of the
coaster.
approaches that were offered required
proprietary
data, and through
were less the
intuitive
for opportunity
compared
to
CAPM.
I
will
mention
adversity of others and used his
twoshrewdness
of the manyto
different
variations
capitalize
on it. of
risk measures that have been proposed
instead
of the
beta.it was popular to
Do you
think
the idea in
of the
In convert
2003, anpeople
article topublished
driving
automobiles?
Ford
Harvard
Business
Journal gotHenry
significant
didn’t because
even invent
automobile
attention
it usedthe
option
prices
his greatest
achievement was
to –calculate
a forward-looking
beta.
an assembly
linevolatility
to make
In utilizing
the approach,
the implied
process
of building
carsmajor
more
in the
an option
price
(one of the
efficient. of
By bringing
down the
components
option pricing)
was
price,out
he made
the invention
backed
of option
prices and
more accessible
and created
compared
to the volatility
of the bonds
issued
by the He
company.
option
demand.
was alsoSince
a member
market makers and traders are always
forward-looking in their estimates of
volatility (what they call the “implied”
volatility), the estimate provided doesn’t
I propose stepping back a bit
suffer from the same “historical” bias
from minute-by-minute or day-bythat the standard regression method
day over-analysis. Instead,
does. The nice thing about this method
determine
if you are
emulating
the
is that
the mathematics
involved
is very
behavior
of
a
vulture
or
of
basic and all the data required could
Roadkill
is the
investor
be roadkill.
obtained at
no charge
from
public
who
gets
run
over
by
the
market
sites like Morningstar. But this method –
buyworks
whenfor
thecompanies
market is high
onlythey
really
that
and
the
other
investors
are
excited
have both traded options and bonds. In
and they
sellmeasure
when the
market
is
addition,
the risk
obtained
using
down
and
other
investors
are
this method conveyed information on
panicking.
don’t capitalize
total
risk and notThey
just market
risk. Why
on
opportunities
because
they
are
is that significant? In valuation, we
look
responding
to
what
has
already
at things from the perspective of the
happened.
marginal
investor who is diversified and
only has exposure to the market risk.
The vulture,
sits onwill
his
Therefore,
using ahowever,
total risk measure
perch,
watching
the
action.
After
most likely lead to more conservative
patiently
he feeds
estimates
of waiting,
value and
result when
in an
the
folly
is
over
and
the
emotional
investor rejecting significantly
more
animal
has
been
caught
in
the
investment opportunities.
headlights and been run over by
Another
alternative
to beta
that gets
the markets.
When
he sees
attention
is
one
that
does
not
relyoff
on
distress, he swoops in, tears
market
all, gets
but relies
instead
someprices
lunchatand
out before
on he,
company
fundamentals.
This
beta
himself, becomes lunch, too.
is either referred to as accounting
betaInorAugust
fundamental
beta.
wateredof 2010
the Amarket
sold
down version of this method would
relate
the committee
earnings change
of a stock
of the
that pushed
to through
that of the
broad
market,
but in
one
the first paved road
canthe
addworld
variables
such as debt
ratios,
– Woodward
Avenue
cash
balances,
dividend
payouts,
etc.,
in Detroit – knowing that his to
make
it morewould
complex
presumably,
product
beand,
more
valuable
more
useful.
On
the
surface,
the
process
as roads got better.
looks promising but the biggest issue
is that
accounting
numbers
are at
The the
common
lesson
of all three
most
four timesfigures
a year. isMarket
of released
these historical
that
prices,
on
the
other
hand,
are
available
they were not only visionaries but
daily data from public sites. Also,
unemotional through economic
it is not uncommon for companies
adversity and in their steadfast
to attempt to “smooth” accounting
climb.
numbers by accelerating or decelerating
the recognition of revenues or expenses,
which means that the figures may not
reflect the “true” risk.
Is there hope?
Asoff.
we can
see, it is hard
to argue flows,
against
According
to money
these
critiques,
but
it
is
also
evident
investors sold equities and
thatbought
the proposed
bonds.alternatives
Why did also
theyhave
sell
shortfalls
of
their
own.
Just
because
those equities? One of the
of primary
these limitations,
though,
reasons was
fearit–doesn’t
media
mean
that
the
concept
of
beta
has
noa
reports had them worried about
value.
Keeping
all these issues
mind,
double
dip-recession.
Yetinthe
beta
can
still
be
used
as
a
risk
measure.
stock market rallied in
Let’s
see how. In fact, the rally
September.
looks like it will yield one of the
best Septembers since 1939.
Beta more
can beinvestors
used
Why didn’t
to see shifts
riskacting like
participate?
Theyin
were
roadkill
- already
wounded and
across
the market.
afraid to take advantage of the
opportunity that August created.
Beta can be used to see shifts in risk
across the market. If one sector of
the market becomes riskier, then its
How
many
of youSince
havethe
been
told
beta
should
increase.
overall
to diversify
placingmust
various
market
beta by by
definition
remain
in different
asset sector’s
classes
at amounts
1, this implies
that another
- small
cap
stocks,
large cap
beta
must go
down
to balance
out. One
estate, international
canstocks,
see thisreal
post-2007,
when the beta
etc.?
Thewas
idea
behind
of equities,
the financial
sector
1.13
and the
this
that
these asset
classes
beta
foristhe
technology
sector
was 1.25.
don’t
move
in tandem
with one
Since
then,
the financial
sector
another – when (continued
one zigs,
the
on next page)
2012:
2010: Fourth
Third Quarter
Page 23
It has been said that he was able to
has
become
significantly
build
Standard
Oil into amore
near-risky,
due
to all ofbythe
questions
monopoly
striving
for remaining
efficiency
regarding
the
underlying
assets
of the
within his own model.
financial firms, pending government
regulation
and manymortgaged
more. Thathisrisk
Andrew Carnegie
ismother’s
reflected house
in the increase
the sector
during ainperiod
of
beta
to
1.63.
In
contrast,
the
beta
economic turmoil. He made a of
the
technology
sector
gutsy
investment
of has
$500gone
for down
10
to
0.97
during
that
period,
reflecting
shares of the Adams Express the
lower
“relative”
Company
andrisk.
that bet paid off well
for opportunity through the
adversity of others and used his
Conclusion
capitalize
on ait.bit
As shrewdness
one can see,tothere
is quite
of controversy regarding beta, its
Do you think
to
shortcomings
andit was
its popular
uses. The
convert people
idea of not
discussion
above toistheclearly
driving
automobiles?
Henry
Ford
exhaustive or mathematically
detailed.
therecommend
automobile
Fordidn’t
more even
detail,invent
I would
–
his
greatest
achievement
was
looking at Pratt’s book, Cost of Capital.
an assembly
linecriticisms
to make
In utilizing
my opinion,
the common
the
process
of
building
cars
levied against regression beta more
are
enough
that
he
was
given
the
efficient.
By
bringing
down
the
Beta at the portfolio level conveys justified, however the alternatives that
opportunity
to make
gutsy at have
price,
made the
invention
more
information
thanother
it does
beenhe
proposed
are also
lacking. As
moves
–
from
steel
to
railroads.
I
more
accessible
and
created
the individual stock level. If one has I have said before, in order to use a tool
he with
had an
abilityofto1.5,
search
demand.
was
also
a member
abelieve
portfolio
a beta
then effectively,
oneHe
must
also
understand
its
that portfolio is thought to be 1.5 limitations. Beta at the stock level has
times more exposed macro-economic problems, but works much better at the
variables than the overall market and portfolio level and can also be used to
will
relatively more
volatile overoftime
seeIshifts
in risk
across sectors.
propose
stepping
back a Finally,
bit
Thebefollowing
is a collection
a
than
a
portfolio
that
has
a
beta
of
1.1.
one
has
to
remember
that
valuation
is
from minute-by-minute or day-byfew of the strategies that I believe
So,
if
someone
wants
to
make
their
not
a
science
and
that
models
are
only
day over-analysis. Instead,
could potentially help our readers
portfolio
less
exposed
to
broad
macro
as
good
as the assumptions
that go into
determine
if you are emulating
the
to preserve and protect their
variables,
then
one
place
to
start
would
them.
Therefore,
one
should
behavior of a vulture or of always
legacies. No single strategy is
be
to replace their
higher reader
beta positions have
a marginRoadkill
of safetyisand
on the
roadkill.
theerr
investor
appropriate
for every
with
lower
ones.
One
might
ask
how
side
of
caution,
because
chances
are –
who gets run over by the market
though, so be sure to consider, with
could
a measure whether
that works
so poorly thatthey
whichever
valuation
measures
you
buy when
the market
is high
your advisors,
these
at the stock level become relevant at useand
will the
haveother
some investors
standard error.
are excited
strategies are appropriate for you.
the portfolio level, since betas of all
and
sellmanagement,
when the market
is
a toolthey
for risk
portfolio
firms in the portfolio are obtained As down
and
other
investors
are
is an invaluable tool. We often
from a regression where the estimates betapanicking.
They
don’t
capitalize
see
portfolios
that are
built
around
have standard errors. The answer lies
on
opportunities
because
they
are
stock selection, without
in averaging. When we average multiple individual
responding
to
what
has
already
to how this addition affects the
stock betas, the resulting average has regard
happened.
think of
billionaires,
aWhen
muchI lower
standard
error, which overall risk of the portfolio. In our
at KS&A, this is a mistake –
vultures
tobeta
mind.
means
thecome
average
is closer to the opinion
The
vulture,
however, sits on his
true beta. Mathematically, it amounts to when choosing components to fit into
perch,
watching
theitaction.
After
your portfolio, we find
much more
Many
of usbelow:
tend to be emotional
the
equation
patiently
waiting,
heeach
feeds
when
valuable
to look
at how
piece
fits
investors - on the days when the
the
folly
is
over
and
the
emotional
Standard
Error
of
Portfolio
Beta
=
into
the
portfolio
as
a
whole,
so
that
we
market is higher, we are happier
animal
has
been
caught
in
the
Average standard error portfolio / √n,
can manage the overall market exposure
and feel quite smug with our
and
been run over
by
where n is the number of stocks
to headlights
the level that
is appropriate
for the
investments. On days when the
the markets.
he sees
individual
investor.When
Although
we may
market is lower, we second-guess
distress,
he
swoops
in,
tears
off
see
great
opportunities
in
a
particular
ourselves and wonder why we’re
some
and gets
out before
sector
or lunch
asset class
or even
security,
not making any money. It’s hard
he,
himself,
becomes
lunch,
too.
that
doesn’t
necessarily
mean
that
asset
not to be on an emotional roller
is appropriate for all of our clients.
coaster.
In August of 2010 the market sold
of the committee that pushed
through the first paved road in
the world – Woodward Avenue
One should always have a
in Detroit – knowing that his
margin
safetybeand
errvaluable
on the
productofwould
more
as roads
got better.
side
of caution,
because chances
are that
whichever
The
common
lessonvaluation
of all three
ofmeasures
these historical
figures
is that
you use will have
they were not only visionaries but
some standard
unemotional
througherror.
economic
adversity and in their steadfast
climb.
Portfolio management isn’t solely a
question of chasing returns – it is more
a question of seeking out risk-adjusted
returns, which means knowing both
what your risk tolerance is and how well
your
portfolio
suits that
tolerance.
off.
According
to money
flows,
and about
If investors
you need sold
moreequities
information
bought
bonds.
Why
did
they and
sell
how our portfolios are structured
those equities?
One of the
managed
to an appropriate
risk level
primary
reasons
was
fear –Advisor
media
for each investor, your
KS&A
reports
hadtothem
worried
about a
looks
forward
hearing
from you.
double dip-recession. Yet the
stock market rallied in
September. In fact, the rally
looks like it will yield one of the
best Septembers since 1939.
Why didn’t more investors
participate? They were acting like
roadkill - already wounded and
afraid to take advantage of the
opportunity that August created.
How many of you have been told
to diversify by placing various
amounts in different asset classes
- small cap stocks, large cap
stocks, real estate, international
equities, etc.? The idea behind
this is that these asset classes
don’t move in tandem with one
another – when one zigs, the
Ken Stern is a registered principal with, and offers securities through First Allied Securities, Inc., a Registered Broker/Dealer,
Member FINRA/SIPC. Asset Planning Solutions is a Licensed Insurance Agency, #OB95262. Ken Stern & Associates (KS&A)
is a Registered Investment Advisor, not a tax or estate planning firm. KS&A recommends that you consult a tax or an
estate planning professional if you feel that these services are necessary for your situation.
There is no certainty that any investment will be profitable or successful in achieving investment goals. The S&P 500 Index
is an unmanaged index that is generally considered representative of the U.S. stock market. The performance of an
unmanaged index is not indicative of the performance of any particular investment. Investments offering the potential
for a higher rate of return also involve a higher degree of risk. Actual results will vary.
Investments in foreign securities may be affected by currency fluctuations, differences in accounting standards and
political instability. These risks are more significant in emerging markets (or concentrations within a single country) and
are subject to greater risk of loss and volatility and may not be suitable for all investors.