The Evolution Of Market Betas – Traditional, Smart And Alternative by Adam Scully-Power, Columbia Threadneedle Investments
- The science of asset allocation has evolved and the array of choices available to build portfolios has become much more expansive.
- Market betas provide asset managers and investors a broad pallet of choices to which portfolios can be built in order to suit different investor needs.
- Understanding market betas and how they can be used within a portfolio represents a meaningful step forward in the evolution of asset allocation.
Asset allocation has evolved over many decades and market experiences. Over that time, there has been an evolution in the way that we understand the components (or drivers) of return. This evolution has helped asset allocators develop a broad array of tools in which to build portfolios with the goal of helping investors achieve better outcomes. In this article, we describe the evolution of market beta from traditional, to smart, to alternative and give some examples of how they can be used by investors.
The most well-known theory for understanding investment return is the Capital Asset Pricing Model (CAPM) in which the main component of return is exposure to the systematic risk of the market. This systematic risk or market risk is known as traditional beta. The amount of systematic risk (beta) that an asset has is measured by how volatile it is compared to the overall market. As the chart below shows, beta is a measure that indicates the degree to which a security or portfolio is expected to rise or decline compared to the market. The beta of the market itself is by definition 1.0 as the market is being compared to itself.
A security or portfolio may have a beta that is more or less than 1.0. For example, if a large-cap U.S. stock fund has a beta of 1.2, the fund would be expected to outperform by somewhere near 20% when the market is up, and the fund may also underperform by a similar magnitude during periods when the market is down.
The most common proxy for the overall market is the S&P 500 Index which is a broad-based market index comprised of 500 U.S. companies. The S&P 500 Index is weighted proportionally based on the market capitalization of each company, meaning larger companies with a great market capitalization get more weight than smaller companies. A potential problem with a market cap-weighted index is that it increases the amount it owns of a particular company as that company’s stock price increases. As a company’s stock falls, its market cap falls, and a market cap-weighted index will automatically own less of that company. A market index that bases its investment weights solely on market capitalization (which is determined by market price) will systematically invest more in stocks when they are overpriced and less in stocks when they are priced less expensively.
However, why does a market index have to be based simply on market capitalization? Are there other factors that can be used to weight an index that offer the potential for improved results?
Academic and industry research has shown that there are a number of market inefficiencies or factors that over time offer a positive return payoff beyond traditional market beta. A factor can be understood as a characteristic that explains the risk and return of an investment. While there are multiple factors which can be macroeconomic, statistical, behavioral or fundamental, the most commonly used factors are the latter. Three examples of these fundamental factors which have been persistent over time are value, momentum and size.
- Value refers to the tendency for inexpensive assets to have above market returns and expensive assets to have below market returns.
- Momentum refers to the tendency for assets that have performed well in the recent past to continue to perform well and assets that have performed poorly in the recent past to continue to perform poorly.
- Size refers to the tendency for small capitalization companies to outperform large capitalization companies.
By weighting an index based on these factors, an investor can capture a return payoff (often called a risk premia) over a traditional beta. For example, to take advantage of the value factor, an index can be constructed by using a rules-based approach to weighting companies by valuation (using a measure such as price-to-earnings or price-to-sales ratios) rather than market cap. In doing so, the value-weighted index is continually rebalanced to weight most heavily those stocks that are priced at the largest discount to various measures of value. This allows an investor to capture the return payoff that is associated with the value factor.
Indices that are constructed using a rules-based approach to capturing the different risk premias embedded in markets are often referred to by names such as non-traditional beta or strategic beta, but the term smart beta has begun to take hold within the industry.
Alternative betas represent the next step in the evolution of accessing market betas. Alternative betas are also based on market inefficiencies and factors embedded in markets. However, they are accessed through investing techniques such as long-short, arbitrage, or relative value investing. By employing a long-short approach, alternative beta strategies seek to profit from these same risk factors or market inefficiencies while minimizing the systematic market risk that traditional betas are exposed to.
Let’s give an example. Above, we discussed the tendency of inexpensive companies to outperform expensive companies over time. An alternative beta approach to this value factor might be to construct an index based on valuation and take a long position in top 20% that are considered least expensive and at the same time take a short position in the bottom 20% that are considered the most expensive, ignoring the 60% in the middle. If both the long and short positions are of equal size, then this strategy would capture the value factor while having little to no exposure to the systematic risk of the market (traditional beta).
Hedge fund managers have been employing alternative beta strategies for years and they are now being used by professional asset managers and made available to retail investors. The benefit of alternative betas is that they provide potential sources of return that are simply not available in traditional markets and have very low correlations to traditional betas making them good portfolio diversifiers. Alternative beta strategies have multiple applications. They can be used to complement an existing hedge fund portfolio by providing additional alternative beta exposures, thus improving portfolio diversification. Alternative beta strategies can also be used to replicate the returns of hedge funds, but often at a lower cost.
The science of asset allocation has come a long way over the past few decades, and the array of choices available to build portfolios has become much more expansive. Market betas, whether they are traditional, smart or alternative, can be accessed across markets including stock, bond, commodity and currency. They provide asset managers and investors a broad pallet of choices to which portfolios can be built in order to suit different investor needs. Understanding market betas and how they can be used within a portfolio represents a meaningful step forward in the evolution of asset allocation.