With U.S. equity markets near their record highs and a bull market run that is starting its sixth year, the potential for a correction is a growing concern. In addition, U.S. equity prices look fairly high when viewed in terms of the PE10 ratio. Another factor that concerns some market watchers is that volatility (as measured by VIX) is at very low levels, reminiscent of 2007. This type of complacency has historically been followed by increasing volatility, as levels return to their historical average, accompanied by a sell-off in higher-risk assets as investors adjust their portfolios to mitigate the effects of higher volatility.
Investors seeking to remain invested in equities at a target level but who want to reduce their exposure to market swings and to mitigate the impact of a rise in market volatility have historically been well-served by increasing their allocations to low-beta market sectors. In this article, I will review the defensive value of low-beta allocations as well as examining the consistency of beta over time.
Beta measures the degree to which a security or a portfolio responds to a move in a benchmark index such as the S&P500. A portfolio with beta equal to 80% (also written as 0.8) tends to go up 0.8% when the market rises 1.0% and vice versa. Beta may be thought of as showing whether a security amplifies the moves in the benchmark (beta greater than 100%) or damps the moves in the benchmark (beta less than 100%).
How Beta Varies by Sector
The SPDR Select Sector ETFs provide a convenient way to break out the sectors of the U.S. equity markets by dividing the S&P500 into nine sectors. These sectors illustrate how much beta varies.
Betas and 10-year average annual returns for major sectors and indexes
The S&P500 has a beta of 100%, by definition. Some readers may be surprised that emerging market stocks have beta of almost 140%, which means that emerging market equities tend to go up (down) 1.4% for every 1% gain (drop) in the S&P500. Even before the market crash of 2008, emerging market stocks were high beta—this is not a new phenomenon.
There are three U.S. equity sectors with betas well below 100%: consumer staples (XLP), healthcare (XLV), and utilities (XLU). It is often believed that low-beta equities have very low average returns. In fact, a well-known but now widely-discounted model of equity returns (the Capital Asset Pricing Model, CAPM) assumes that beta of an equity or asset class corresponds directly to expected return. High-beta asset classes have high expected return and vice versa. Low-beta equities have historically substantially out-performed what would be expected on the basis of CAPM, however, and the past ten years is no exception. These three sectors have all out-performed the S&P500 over the past ten years. The return numbers shown here are the arithmetic averages, including reinvested dividends.
Low Beta Asset Classes in 2007-2008
The first question that is worth asking about beta is the degree to which beta corresponds to losses in really bad market conditions. In the table below, I have tabulated beta calculated using three years of data through 2007 for each of the funds above, as well as the returns for each of these in 2008.
Beta calculated through 2007 vs. 2008 returns
The three sectors with the lowest betas going into 2008 (consumer staples, healthcare, and utilities) had an average return of -22.3% in 2008, as compared to -36.8% for the S&P500. An equity tilt towards these lower beta sectors could have reduced losses in that year.
Consistency of Beta through Time
The astute reader may notice that the betas calculated using ten years of data through May of 2014 (shown in the first table) are, in some cases, quite different from the betas calculated using three years of data through December of 2007 (shown in the second table). Beta varies through time. The betas calculated using three years of data through May 2014 provide an interesting contrast to the three-year betas through the end of 2007.
Comparing betas for two 3-year periods
We are looking at two distinct 3-year periods, separated by almost six and a half years and, in general, low-beta sectors at the end of 2007 remain low-beta today and high-beta sectors back then are still high-beta. The two most notable exceptions are international equities (EFA) and the technology sectors (XLK). These changes notwithstanding, the three sectors with the lower betas in 2007 also have the lowest betas in 2014.
There are a number of factors that will determine whether any sector will weather a broad market decline better than others. Beta is one important factor, but there are others. In 2008, the financial sector suffered disproportionately large losses—well beyond what would have been expected on the basis of beta alone. The underlying drivers of the 2008 market crash were most severe in the financial sector. Small-cap stocks, by contrast, fell considerably less than the beta value of this sector would have suggested.
Low-Beta and Asset Allocation
Low-beta asset classes have historically provided some protection from market declines and increasing volatility. There are a range of other considerations that potential investors should consider, however when creating a portfolio. The selection of individual asset classes should be made with consideration of the characteristics of the total portfolio, including desired risk level, interest rate exposure, and income generation. The target for total portfolio beta is primarily determined by an investor’s total risk tolerance. A target beta level can be achieved both by choosing how to allocate the equity portion of a portfolio among sectors and by varying the balance between equity (stocks) and fixed income (bonds) investments. Fixed income asset classes tend to have very low—even negative—values of beta. In my next blog entry, I will explore these two approaches to managing beta at the portfolio level.
History suggests that low-beta sectors can provide some protection from market downturns. The length of the current equity rally, and the substantial increases in equity valuations in recent years, are motivating some investors to consider their best defensive alternatives to protect against the inevitable reversal. The question for investors to ask themselves is whether they are best-served by reducing portfolio beta by reducing their exposure to equities, by shifting some portion of assets from high-beta to low-beta sector, or both.