“A rising tide lifts all boats”—that is the best way to begin this edition of The Thoughtful Arbitrageur, as we explore the uses and misuses of the beta coefficient. Commonly referred to as beta, this statistic measures systematic risk. Put more simply, beta measures a security’s correlation to the general market.

To review, going back to our B-school days, a stock with a beta of 1 will move directly and equally with market fluctuations. Therefore, if the market is up 10%, we should expect a 10% return from this asset. By extension, a security with a beta of 0 is perfectly uncorrelated to the market and a -1 beta implies that a security should move in an equally opposite direction to the overall market. Since beta also measures magnitude, a security’s beta can be much greater than 1 or -1 depending on how dramatic its movements are relative to the market averages.

Other logical caveats when applying this tool are that securities that trade in different markets are not comparable because their correlations will be different. A security that moves at a +1 to the Bovespa for instance, might have a .25 versus the S&P. Another conundrum is that a high beta stock may be less risky than one with a lower beta. While generally high beta implies greater volatility, a security with a low beta may be highly subject to risk, as its ultimate standard deviation may be much greater.

Put another way, the high standard deviation implies a stock with a much more aggressive profile away from general securities movements. An example of this may be a biotech company awaiting an FDA approval. Its beta may be close to 1 for a period of time, yet may ultimately move wildly when approval time nears. This deviation is categorized as alpha and explains an equity’s unsystematic variations, or those not explained by the market.

Managers who capture alpha in a low-risk fashion are, of course, highly sought-after since they should over time outperform their peers. Along with other measurements such as Sharpe ratios and variance modeling, investors attempt to predict fund performance, and therein lays the rub. An investor simply cannot rely on a statistical black box. There are too many cautionary tales warning against these systems. In fact, one must clearly understand what comprises a securities beta or any measure of fund performance. These are just some of the cautions when applying beta, a topic we will definitely be visiting again.

Perhaps our use of and attraction to beta comes from the fact that it is relatively easy to understand. Going back to our high school algebra days, we are simply correlating two sets of variables, one tracking an asset and the other the overall market. In fact, our brain is wired to decipher information in this configuration. We constantly compare sets of events to mentally adapt to new situations. Human beings will readily try a gelato because it looks and is served just like ice cream. We associate eating ice cream with joyful and satisfying experiences. Thus, our correlating brain signals a cause and response. In this case, it is reaffirmed when we taste that delicious gelato. However, that type of thinking can fool us at times. Like a mouse that gets caught in a trap by reaching for the alluring aroma of a piece of cheese.

More germane to the subject, is the complaint that many money managers are “beta chasers.” Asset management is a tough job—if it was easy, the rewards would not be so great. Fund executives learn early on that performance that matches an index is much more tolerated than performance that lags an index. This holds true even if the latter eventually produces better long-term returns. Since we live in a world that demands constant response to clientele, many managers overtly, or subliminally, chase beta. Ironically, it is that pursuit that sometimes leads to underperformance. With that said, here are some of the important considerations when applying the beta coefficient:

Beta is in the eye of the beholder

One can find many variations of a security’s beta, it all depends on where you look. For example, the beta you find in Value Line may vary from one reported on Yahoo Finance. Nonetheless, if you are using beta in a serious fashion, you had better start with an understanding of what you are dealing with. Some services use weekly prices, other use daily. There are variations in the time frame a service considers, and then there is the more pressing concern, what your asset is being compared to. Is the S&P representative or would the Nasdaq 100 be more suitable? At least a baseball manager who relies on a player’s batting average knows that in the abstract that .300 means 3 hits out of 10 at bats. With beta, the foul lines may change on every pitch.

Managers need to create their own versions of beta and constantly retest their assumptions. It all starts with these basic questions: Are the prices I am looking at representative? Is the sample large enough? How accurate is the sample? What are the correct benchmarks? A fund that invests in large liquid industrial companies will give a more accurate picture of beta than one where prices are more subjective, such as in private equity. A larger sample is almost always better than a smaller one. Applying these types of disciplines, one sees the caution of investing in assets with a brief, or unreliable, however stellar return.

Yet another issue is what I call the “dog walking the owner syndrome.” This is where an equity or group of equities becomes such a large part of an index, that it overwhelms the performance. At that point it begs the question, “is the market affecting my investment or is it the other way around?” These matters require a great deal of insight and repeated appraisal, and to ignore them would be foolish.

Finding the proper benchmark looms large when viewing beta. An investor needs to continually test his sample versus different indices. In this way, the manager learns just what drives performance. The chairperson of Pepsi may be more interested in her performance relative to Coca Cola, than the Russell 2000. That information, though painstakingly derived, proves invaluable.

Beware of special situations

Investors treat stocks differently at various stages of the life cycle of a company. A recent IPO may react in a contrary fashion to a well-established company. There are also different investor behaviors in a penny stock when compared to one with a $500 handle. The same company, in this case, displays different reaction to the markets depending on factors absent the fundamentals.

More crucial are special situations such as M&A, spinoffs or the potential of a securities addition or subtraction from a particular index. Not factoring in these possibilities can cause the beta watcher a great deal of angst. This argument can be logically followed by the admonition that man does not live by fundamental analysis alone. To discount external or special situations can render statistical examinations meaningless.

Low Beta may mask risk

As we mentioned earlier, a beta below 1 may be a function of a company that tracks the market in a less varying fashion, yet still has the potential for outsized returns. This is due to its unsystematic or security specific risk. Professionals, as well as the weekend investor, need to be vigilant for risks that are indigenous to a particular well-loved stock. The “Tylenol Scare” that affected the share price of Johnson & Johnson comes to mind. Until that point, JNJ was viewed as a typical “widows and orphans” stock. The vulnerability of a staple product like Tylenol, in such an unusual fashion, greatly disturbed the investing and general public. Some may argue that this type of risk is unknowable; however, that is exactly what “Black Swans” are made of. The astute investor considers the entire range of possibilities. I remember hearing a famous chief executive relaying that it was “monsters unforeseen” that kept him awake at night. In this case, a bit of paranoia is a good thing.

Lastly, the most significant reflection should be on the projection of an equity’s future beta coefficient. Smart business people understand that the past, while it may be prologue, can be nothing more than yesterday’s weather report. When assessing an investment’s potential, where it fits in one’s definition of the beta continuum is essential.

For now, we will stop here. However, beta, Sharpe ratios and other types of arithmetic based measurements will be a recurring theme, since they clearly drive markets and our ability to decide.

A brief follow-up on our Real Estate piece

We received many comments on our recent piece on Real Estate. Given how central it is to the global asset base, it does not surprise us. In fact, in the last few days there have been reports that signal lower real estate prices. One in particular from Zillow offers a dramatic reassessment of downside in the housing market. Until the entire foreclosure crisis is solved, this may continue to be the case.

Another topic mentioned was our comment of more real property ultimately finding itself in the hands of REITS or Trusts. Again, we caution that our views take into account a macro assessment. What happens in places like Manhattan or Beverly Hills is not particularly indicative. This vision is more based on what goes on in the many counties that make up the backbone of the United States. The fact is that less of a real estate burden to these folks means a more comfortable overall lifestyle. This is especially so given a declining real estate market.

The “Tara effect” was our view that many of the Baby Boom generation were influenced in their desire for “bigger and better” by popular media. Popular culture in the form of movies like “Gone with the Wind” or television shows such as “Dallas” or “Dynasty” inspired a desire for the grand entrance. These stories implied that “success and smarts” are directly equal to square footage. In fairness to “GWTW”, it is truly an American classic. Still “Tara” deserves as much onscreen credit as Vivien Leigh. In fact, look at how many of our homes are of the “Center Hall Colonial” fashion. The National Association of Builders should pay the creators of “GWTW” a royalty for every Colonial sold. The sober reality is that you cannot appreciate the upkeep and commitment through a television screen.

Encouragingly, it seems that the millennial generation may be displaying an opposite feeling toward this type of conspicuous consumption, and this may be a good thing. According to a recent New York Times article, “As Young Lose Interest in Cars, G.M. Turns to MTV for Help”, General Motors executives are dealing with the fact that most young people do not care about automobiles as much as generations past. Their ambivalence can be summed up in the following quote: “They think of a car as a giant bummer. Think about your dashboard. It’s filled with nothing but bad news.”

The piece also provided empirical evidence backing these claims. It seems that a generation that values material goods such as fancy cars and expensive housing as less important, is an inspiring sign. We well know how these “toys” can literally sap our asset base and wear us out mindlessly. Considering what our economy is currently going through, impulsive consumption seems akin to puffing away on tobacco, given what we know now about the health risks. Quite possibly, in an inadvertent way, we have taught our offspring a valuable lesson that may significantly affect future spending—”all that glitter is not necessarily gold.”

Until the next time…. The Thoughtful Arbitrageur.

Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.

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