Beta's been declared dead for so long, by so many, that it's tempting to dismiss the risk metric as a museum piece. Yes, it's hotly debated, and probably always will be. Like any quantitative tool, it comes with its own brand of benefits and flaws. But even a disputed beta remains a potent force in finance.
The most conspicuous evidence of the risk metric's muscle is the explosive rise of ETFs, the majority of which can be thought of as exchange-listed celebrations of beta's fundamental principles. Focusing on the risk/return profile of "the market," in other words, has never been more popular.
Beta, of course, is the offspring of the Capital Asset Pricing Model, which laid much of the academic groundwork for index funds. CAPM's instruction for looking at securities and portfolios through beta-colored glasses is a quantitative statement that return and risk are related in a generally predictable, linear way. Mathematically, the model declares that higher returns come only with higher risk. To cut to the chase: Investors are rewarded primarily for market risk-- i.e., beta--over time.
The fact that active managers have a hard time beating a relevant index suggests that investors should think twice before ignoring CAPM. Nonetheless, the model and the other theoretical foundations that make up what's called modern portfolio theory (MPT) have long suffered intellectual assault. That includes the charge that investors aren't fully rewarded for beta risk as CAPM predicts. Higher betas, some empirical studies show, don't necessarily bring higher returns; meanwhile, lower betas don't always lead to lower returns. As a result, regressing return against beta risk may show that the capital market line is flat rather than upward sloping, as per CAPM.
To the extent that CAPM stumbles as a predictor of returns, two basic theories compete for explaining the shortfall, according to Prof. Eugene Fama. One comes from the behavorialist school of economics that argues that investors go to extremes by paying either too much or too little for stocks relative to what CAPM predicts. A competing theory is that CAPM is too simplistic for the real world and therefore, investors need a more nuanced pricing model. In fact, academics have built a number of alternative models over the years.
CAPM was never intended as a forecasting tool for securities prices per se. Rather, its raison d'?tre is one of deciphering relationships between variables with an eye on establishing a framework for building portfolios and analyzing securities, in reference to the total market portfolio, which goes far beyond equities.
Nonetheless, some conclude that the various indictments of CAPM represent a death sentence for beta. Yet the late Fischer Black, who helped revolutionize finance with the design of the Black-Scholes Option Pricing Formula, saw it differently. In 1993, Black wrote that beta is a valuable investment tool if the capital market line is as steep as CAPM predicts. But if the line is flat, CAPM is even more valuable, he added.
Black reasoned that beta isn't wrong; rather, the real world frictions make it difficult to fully exploit beta. That offers opportunities for savvy investors to capitalize on the inefficiency. Burton Malkiel echoes the point in the latest edition of his book, A Random Walk Down Wall Street (Norton, 2007), advising that investors "should scoop up low-beta stocks and earn returns as attractive for the market as a whole but with much less risk."
In spite of the attacks, beta still holds enormous sway over the way investors think. Financial historian and consultant Peter Bernstein devotes his latest book to profiling several of the more notable examples of the expanding uses of MPT (or, Capital Ideas, as he brands it) in recent years. "Despite all this turmoil, the applications of Capital Ideas have developed into orthodox operating procedures in the daily management of investment portfolios and trading activity in the financial markets all around the globe," he writes in Capital Ideas Evolving (Wiley, 2007). A key reason: The basic trade-off between risk and expected return still "infuses all investment decisions," he opines.
A beta-informed view of the capital markets seems likely to endure, but that doesn't mean that its advocates are forever stuck in yesteryear. The risk metric's uses evolve, albeit as a continuum of change that links the original beta research of the past to the leading-edge applications of the present.
One example is grafting beta-oriented concepts onto asset allocation strategies. This seems reasonable if you consider that CAPM's flaws are reportedly minimized in the context of broad portfolios compared to individual securities analysis. Several studies over the years suggest that broader is better for indices and strategies when it comes to finding relevance between beta and the real world.
Among those who walk this path of reasoning is P. Brett Hammond, chief investment strategist at TIAA-CREF Asset Management, which oversees more than $400 billion. Beta, Hammond told Wealth Manager in a recent interview at the firm's New York headquarters, is hardly dead. In fact, in a recent research paper, Hammond takes a fresh look at beta-inspired analytics for modeling multi-asset class portfolios that add alternative assets--such as hedge funds and venture capital--to conventional portfolios of stocks and bonds.
The paper, "Reverse Asset Allocation: Alternatives At The Core," draws on an analytical framework that was developed at TIAA-CREF by Martin Leibowitz (now with Morgan Stanley) with assistance from Hammond and others. It provides a strategy for comparing the investment opportunity set in terms of adjusted betas--adjusted in the sense of looking at asset classes through a U.S. equities prism.
Expected returns of hedge funds and government bonds, for instance, are measured relative to the redrawn capital market line using U.S. equity beta and the "risk-free" return of Treasury bills. To the extent that an asset class offers expected return above the new capital market line, the return premium is considered structural alpha. Unlike the standard definition of alpha, which is a function of active management, structural alpha in this case is a premium generated from diversifying into passively managed asset class betas beyond domestic equities. For instance, the nearby chart (for illustrative purposes only) shows that REITs have roughly half the expected beta of the U.S. equity market, but offer roughly 200 basis points of expected structural alpha.
One reason for looking at asset classes this way is that it reframes the analysis in terms of expected returns and risk relative to domestic stocks. For good or ill, most investors use domestic equities as a reference point. Adding alternative asset classes typically centers on how those additions will modify a conventional stock portfolio.
Hammond's revised beta formulation maintains a reference point for how investors think while overcoming the challenges that arise when using alternative assets in an MPT-based structure. While the analytics behind the reverse asset allocation strategy are U.S.-equity oriented, the foundation starts with alternative asset classes as core holdings. That's the opposite of the traditional approach; thus the label "Reverse Asset Allocation."
Why flip asset allocation on its head? Because the conventional process of starting with domestic stocks and adding alternatives can lead to extreme allocations when using portfolio optimization techniques--extremes that few investors are willing to tolerate, says Hammond. "Reverse Asset Allocation" offers a substitute methodology that keeps asset allocations practical (in terms of what investors will tolerate) while staying true to MPT's ideas.
In fact, looking at beta from different perspectives has been a lively line of inquiry for years. A recent example is "A Factor Approach to Asset Allocation," a 2005 paper from The Journal of Portfolio Management. Building on a long history of research, the paper identifies global market factors "that can be used to diversify the exposures in a portfolio." Examples include earnings yields, market premium changes, real interest rates and spreads in short-term interest rates across currencies. The authors, who work at Los Angeles money manager Analytic Investors, note that these and other global factors have returns that are uncorrelated with one another. Introducing these factors into conventional stock/bond portfolios can improve the overall risk-adjusted profile.
"What's striking when I talk to clients is that everyone's so concerned with the equity market," says Harindra de Silva, one of the paper's authors and the president and a portfolio manager at Analytic. "But there are 10 other sources of return. If you're so concerned about the [equity] market, that probably means you have too much risk allocated to that one source of return." That suggests looking for alternative sources of returns, including the risk factors in the paper, he says.
"What we call factors are basically other betas," de Silva continues. Allocating part of a portfolio to these other betas in a systematic way helps minimize equity risk while tapping equity-like returns, he argues. "The basic idea is that there are these [alternative] systematic sources of return.
No less is implied by MPT's founding document--Dr. Harry Markowitz's "Portfolio Selection." The 1952 paper that inspired CAPM counseled that an efficient portfolio--one that maximizes return for a given level of risk--is driven by an enlightened mixing of assets with low covariance. The initial presumption was that the risky assets are stocks, although refinements to the theory have expanded the playing field to include various equity and bond indices along with so-called alternative betas such as commodities, currencies and beyond.
What's old is sometimes new in portfolio theory, and very much alive. O death, where is thy sting?
JAMES PICERNO (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.
