All investments carry risk; that’s what allows them to offer their respective rewards. About the reward: it’s obvious that the greater the risk that investors take, the more they have to reap; investment beta is what allows said investors to figure out what they actually have to lose.
What is Beta?
Simply put, beta is the quantification of the systematic risk of an investment relative to the market, which the S&P 500 represents, as a whole. Beta measures risk by analyzing the volatility of any security; if the calculated number for ‘risk’ is greater than 1.0, the security is more volatile than the S&P 500 and vice versa.
By understanding the method used to calculate beta, it becomes easier to apply it to your own analysis. In statistics, beta would represent the slope of a regression curve designed to fit a set of data. Applying this statistic to finance works in the same way; the dataset is the securities performance relative to the market and the respective slope is investment beta.
Beta is often also used in conjunction with ‘R-squared’, a statistical measure that indicates the strength of a relationship. A high R2 value means that the benchmark—typically an index being used to represent a market (like the S&P 500)—is relevant to the security being compared. A low R2 value means that the movement of the benchmark doesn’t correlate well with that of the security and so the accuracy of the calculated beta value is limited.
Rp represents portfolio return, Rm represents market return (like from the S&P 500), and Rf represents the risk-free rate (e.g. 5% for the S&P 500). The intercept represents alpha because, if a portfolio is statistically coming out of an investment with more return (Rp – Rf) than the market (Rm – Rf), then it has an ‘edge’ due to its superior performance (positive alpha). The opposite would hold true had the portfolio performed worse (negative alpha).
How is Beta used?
Its primary application is in the Capital Asset Pricing Model (CAPM), an analysis that allows investors to determine the relationship between risk and expected return for any given security. Any security that maximizes reward while minimizing risk is the most desired, and because this analysis makes it easy for investors to find such securities, CAPM is used widely throughout finance. It’s most ubiquitous surrounding pricing securities that carry a lot of risk and for calculating the cost of capital.
Some investors argue that beta is useless as an indicator because business fundamentals determine risk, not volatility. Short-term traders, who most commonly use technical analysis with indicators like beta, stand to lose more from volatility than do long-term investors—the primary critics of the measure. The application of the metric depends entirely on the style of investing.
What about Alpha?
Alpha is a term that describes the performance of a security compared to the rest of the market; it’s a measure of relative return. It’s commonly also referred to as an ‘abnormal rate of return’ because, according to the efficient market hypothesis, there’s no way to consistently beat the market and all excess growth will eventually even out. The hypothesis isn’t accepted by all, however, and so the term alpha is the more popular counterpart.
Just like with beta, alpha needs to be gauged against an index that represents the entire market—something like the S&P 500. Only from there can it be determined if a security, portfolio, or even wholly investment strategy is beating the market. Due to it being a relative measure, alpha can be either positive or negative.
Smart beta was firstly theorized by economist Harry Markowitz as part of a ‘modern portfolio theory’—an investment strategy that works to maximize returns while maintaining moderate levels of risk. They typically follow indices while considering factors like volatility—derived from beta, liquidity, size, etc.
Though investment is typically considered an art as much as it is a science, smart beta refers to a set of rules that constrain everything down to only the latter factor. Investment portfolios that are considered smart beta follow long-only rules-based strategies that hope to quantify all investments. Most smart beta funds on the NSE have performed better than the NIFTY 50 index which has provided returns of about 17% in the last 5 years.