✌️ Welcome to the latest issue of The Informationist, the newsletter that makes you smarter in just a few minutes each week.
🙌 The Informationist takes one current event or complicated concept and simplifies it for you in bullet points and easy to understand text.
🫶 If this email was forwarded to you, then you have awesome friends, click below to join!
👉 And you can always check out the archives to read more of The Informationist.
Today's Bullets:
Beta Simplified
Beta in Asset Classes
Volatility and Portfolios
Inspirational Tweet:
Beta.
We hear it all the time, and it's an important concept (and measure) in investing.
But what exactly is beta, and how does it both influence decision-making and impact returns for portfolio managers and investors?
Don't worry, this isn't going to be a math class today, we will keep it super high-level, especially for the new investors.
So, grab your favorite cup of coffee and settle into a comfortable seat for this Sunday's Informationist.
🤓 Beta Simplified
To put it simply, beta (β), is a measure of a security's volatility in relation to the overall market.
It's a numerical value that indicates how strongly a stock or portfolio's returns are expected to move in relation to overall market movements.
A beta of 1 indicates that the stock's price is expected to move with the market.
Lock-step.
A beta greater than 1 indicates greater volatility than the market, meaning the stock is more sensitive to market movements (higher potential returns but with higher risk). Conversely, a beta less than 1 indicates less volatility than the market.
And a negative beta means that the security moves in opposition to the market to some degree. A beta of -1 would mean that if the market rises 5%, for instance, the security would fall 5%, and vice versa.
In this way, investors use beta to gauge a stock's risk in comparison to the market. In other words, investors expect to be compensated for additional volatility in an investment.
A high-beta stock is considered riskier but is expected to offer higher long-term returns, which fits well with aggressive investment strategies (Think: Cathy Woods' ARK Innovation ETF) .
Low-beta stocks (Think: Utilities), appeal to investors seeking lower risk, the trade-off, of course, is likely lower long-term returns.
A note on risk premiums.
as you can see, it is difficult to talk about beta without also discussing risk.
Risk premium is the added return over the risk-free rate that investors require to be compensated for risk of a particular investment.
The risk-free rate is typically quoted as a 3-month T-Bill rate.
So, if this rate is 5%, investors may require 8%, 12% or even more return for an investment that is highly volatile.
The difference between the required yield and the risk-free rate is the risk premium:
8% required return - 5% risk free rate = 3% risk premium
Simple, right?
Now let's dig into some different asset classes and the betas associated with them.
🧐 Beta in Asset Classes
Tech Stocks
The most often cited reference for beta is stocks, and usually it is tech stocks.
In the overall stock market, betas can vary significantly. Utilities (ATT, Verizon) or consumer staples (Coca Cola, Kraft, etc.), typically have lower betas, as they are less volatile. As such, risk premiums for these stocks are lower.
In contrast, tech stocks (AMD, NVIDIA, etc.) have higher betas because of their greater volatility.
See, tech companies, particularly high-growth ones, often use financial leverage. This leverage, or debt, can fuel the high growth.
It's also riskier.
Yes, it can amplify returns when times are good, but can also cause losses when revenues decline, due to the obligation to service debt regardless of financial performance.
This increases the company's beta, as its stock becomes more sensitive to changes in market conditions and interest rates.
iInvestors demand higher risk premiums to be compensated for the resulting volatility.
As you can see, the drawdown for high beta stocks (blue) in the market shock of 2020 was deeper, and now the recovery has been steeper than the overall market (red).
Please note, not all of these high beta stocks are in tech, but many have some sort of leverage and, hence, associated volatility. Here are the consituents of the High Beta ETF below:
Gold
Gold has long been considered a safe haven asset, often having a low to negative beta in relation to the stock market. As such, it can act as a hedge during market volatility or downturns.
The risk premium for gold varies, depending on factors like inflation expectations and geopolitical tensions.
Here is how it performs versus the S&P 500:
In contrast to high beta stocks, gold's drawdown was lower and its return has also been lower than the overall market. Its low beta nature means lower returns for overall risk assets in a typical environment, but also risk mitigating in drawdowns (like 2020).
Bitcoin
As a relatively new asset class, Bitcoin experiences periods of high volatility (I know, understatement of the year), and so, it carries a high implied beta relative to traditional financial assets, like stocks and bonds.
To wit:
I have said this before, high volatility in a rising asset is a good thing, as long as you can take a long-term view. I mean, yes the drawdown in 2020 was steeper for Bitcoin, but how can you argue against this return versus the overall market?
This all makes sense, yes? Highly volatile assets carry high betas versus the broader markets, and therefore, carry higher risk premiums to the risk-free rate.
But what about the industries within those industries?
Let me explain.
See, gold may have a low beta to the overall market, but gold miners, the companies extracting this gold from the ground, have higher betas to the overall market.
Why?
Because they have a higher beta to gold itself.
See, the stocks of gold mining companies have high betas versus the price of gold because their operational leverage amplifies the impact of gold price changes on their profitability.
In other words, if the price of gold rises, the revenues of gold mining companies often (and should) increase in multiples of this.
This is because mining companies' operational costs remain relatively fixed (labor, mining equipment, etc.). And as the price of gold rises so do the margins of profitability.
When gold prices fall, so do their margins and profitability.
And so, the beta of gold miners relative to gold itself is typically greater than 1, indicating a more pronounced reaction to changes in the price of gold.
You can see here, the smaller miners (Junior) have an even higher beta to the price of gold, as their fixed costs make up a larger portion of the overall profitability equation.
As a result, their betas are even higher than the more established and larger mining operations.
Right now you may be thinking, how about Bitcoin and its miners?
Similar to gold miners, Bitcoin mining companies have betas that are high relative to the price of Bitcoin.
The capital costs and input costs of mining (ASICs and electricity) are relatively fixed, making profitability highly sensitive to Bitcoin price.
And so, no surprise, Bitcoin miners' stock prices experience greater volatility compared to the already volatile bitcoin prices.
One thing to note in this chart, is that there is a halving coming up next month, and so the Bitcoin miners are likely not keeping pace with the price of Bitcoin as they normally would, due to the near-term cut in profitability (half the reward next month vs. this month).
Even so, you can see the exaggerated moves of miners prior to this latest period.
😵💫 Volatility and Portfolios
Putting it all together, we can contrast two styles of investing to see how different managers employ beta or avoid it.
Cathy Wood uses beta as rocket fuels for her portfolios.
Her style is high risk, and so one should expect high returns over long periods of time. Just check out the chart below to see how volatile the names in her portfolio are versus the overall S&P 500.
Interestingly, though the ARKK ETF created massive returns in the meme stock period of 2020 to 2021, the ETF has struggled to keep up with the AI-led rally lately.
Live by the sword, die by the sword.
In almost perfect contrast, arbitrage funds, specifically merger arbitrage, seek to create returns regardless of market direction. To do this, they create portfolios that are completely neutral beta.
Perfectly hedged.
And while this can be a great strategy in times of economic expansion and high risk free rates, it has not been so good since Zero Interest Rate Policy (ZIRP) of the 2000's thus far.
Though the volatility was near nil, these are pretty dismal returns versus the overall market for the last few years.
And so, there is some truth in the saying, high-risk, high-reward.
I, for one, am happy I left the arbitrage industry long ago.
Perhaps if we once again enter a period of higher risk-free rates along with a spate of corporate consolidation, this will once again be an attractive strategy.
But for now, it pays to find and take appropriate risk in portfolios, as long as you can maintain a long enough time horizon for investing.
That’s it. I hope you feel a little bit smarter knowing about beta and are ready to start incorporating these types of analyses in your own investing.
If you enjoyed this newsletter and found it helpful, please share it with someone who you think will love it, too!
Talk soon,
James✌️