Over the last few weeks, we have analyzed the risk of several investor portfolios and ETFs. One metric we constantly use to assess risk is beta. At Trivariate we use the median of four beta horizons as an attempt to marry near-term conditions with the longer-term market sensitivity of each stock. Nonetheless, betas can change when there is sharp price action, and hence, we analyzed the betas of the top 2000 US equities to identify anomalies and to assess how alpha potential varies by beta decile across the market.Among the mega-cap stocks, it appears that the median growth stock has average beta, but the betas of non-growth stocks have plummeted to lows. Essentially, among mega caps, if you are not a Mag 7 stock, your beta is low. The bottom 40% of mega cap stocks have not had betas this low since the TMT bubble in 2000. For many generalist portfolio managers, it has been a challenge to correctly size Semiconductor positions, as betas are both high and disperse vs. history. On the flip side, Insurance, Energy, and Utilities companies all have low beta vs. their own histories, though we suspect they will be less defensive in a downturn than current betas imply.
Across the market, there is a clear inverse relationship between beta and alpha. Lower beta stocks have higher alpha, and the higher beta stocks have lower alpha and higher volatility of beta. The pattern perfectly rank orders across beta decile for the overall market over the last 25 years. The same pattern of the higher the beta decile the lower the realized alpha held in both growth and value stocks.
Five percent of stocks have beta less than 0.25, and the median stock in this low beta group had 10.9% annualized alpha. On the contrary, only 5% of stocks have a beta higher than 2.21 historically, and that cohort realizes an annual NEGATIVE alpha of 620bps. Assuming the historical betas by decile hold constant, we simulated the expected return (market assumption*beta + alpha) for various S&P500 return scenarios. If the S&P500 is not up at least 7%, the lower the beta the better. If the market is up between 7% and 12%, there is not a meaningful implied total performance differential by beta decile. Once the market’s returns are above 12%, investors need to seek higher beta, as capturing more of the market performance offsets the alpha destruction that comes from the average high beta stock.
Among high quality stocks, the total implied return is the highest for the lowest beta decile of stocks if the S&P500 is up less than 8%. Above 8%, the bottom decile of beta has the highest implied returns. We show the return required to sell low beta stocks and move to higher beta by sector. Only if the market returns more than 18% should investors chase beta in Communication Services and Real Estate. Higher beta stock selection makes sense when the market is up more than 4% in Utilities and 6% in Technology. Stocks under these assumptions are…