Investing is difficult, yet relatively simple. Developing a view then expressing it by buying or selling an asset sounds very simplistic. However, timing is just as important. Once a direction is known, structuring a trade is important and beta can help in this regard.
Beta is a statistical concept that measures a variable’s relative sensitivity to another. It can be applied to most disciplines but in terms of finance, stock beta measures the relative movement between a wider index like the FTSE 100 and an individual stock. There has been a lot of research published either in favour or dismissing beta as an accurate tool for predicting stock returns, yet in many university classes, beta is taught in a very theoretical way.
The clear drawback of a three-year beta for instance, is that it is historical. It tells the investor what the relative movement has been like over the past three years but gives no predictive indication for the next three years. Betas can change depending on a multitude of factors, such as economic conditions, earnings results and business strategy. That said, they are useful for investing purposes because they do not change too often. The index has a beta of 1, so if the growing fashion company, Boohoo, had a beta of 2.3 it means the stock could rise 2.3x more than the market but equally, fall 2.3x faster should the market decline.
How to Read It
Beta is effectively a volatility measure so if a stock portfolio had a large weighting of high beta stocks, volatility would be high. Beta hedging is a tool for constructing trades to minimise volatility.
Take the spread trade idea: long Boohoo/short Marks and Spencer (M&S). Boohoo has a beta of about 2, mainly because it has experienced rapid growth in sales since going public a few years ago. M&S, on the other hand, has a much lower beta of around 0.8. Going long Boohoo and shorting M&S in a rising market means Boohoo should outperform M&S and will increase much faster.
However, as mentioned above, the trade will be fairly volatile because M&S is effectively matching the market while Boohoo is double that. If the investor had $10,000 to allocate to this spread and divided the capital 50/50, that would on the surface seem like a sound idea. The problem with that play is that the long side will be very volatile.
If the market became quite defensive, Boohoo might fall rapidly causing the trade to hit the effective stop loss. Beta hedging effectively means more capital should be given to the lower beta side and vice versa. In this case, given the respective beta’s, $2,857 should be allocated to Boohoo while $7,142 should be given to M&S.
The downside to such a structure is because the betas are so different, if M&S had a bad week the spread is proportionately hurt more, however this should be offset with the less volatile profile of M&S. Ideally, it would be better to get stocks with a lower gap, for example, 1.2 in company A and 1.5 in company B. In this case, capital weighting would be closer to 50/50.
Given the nature of the market and current positive fundamentals, higher beta stocks should overshoot the market. If Trump does not disappoint, higher beta plays, or going long cyclicality, should pay good dividends over 2017.