Beta is Back

How
Does
Beta
Work?

Sharpe’s
insight
was
that,
because
investors
can
diversify
to
protect
against
other
equity-related
risks
(such
as
the
possibility
that
specific
companies
or
industries
will
founder)
what
matters
for
determining
a
portfolio’s
expected
return
is
its
aggregate
beta –
the asset-weighted
average of
its
equity
holdings.
Per
Sharpe’s
analysis,
beta
cannot
foretell
how
the
overall
market
will
fare,
but
it
can
suggest
the
level
of
a
portfolio’s
returns,
assuming
a
given
stock
market
result.

To
be
sure,
beta
cannot
specify
every
company’s
outcome.
It
describes
the
conduct
of
large
numbers,
not
single
situations.
Thus,
when
Berkshire
Hathaway
(BRK.A) and
Enron
each
faced
a
losing
stock
market
in
2001,
while
possessing
similar
betas,
Warren
Buffett’s
firm
managed
a
small
profit
while
the
latter
lost
97%.
In
addition,
betas
cannot
be
determined
in
advance.
They
can
be
estimated
from
stocks’
historic
returns
but
not
definitively
known
before
the
fact.

All
fine.
Nobody
expects
beta
to
predict
either
individual
stocks
or
portfolio
performances
over
short
periods.
Sharpe’s
hypothesis
addresses
general
long-term
actions.
To
cite
one
example,
it
implies
that,
if
the
stock
market
were
to
increase
over
several
decades, growth
stocks should
outgain value
stocks,
because,
on
average,
they
typically
have
higher
betas.

Beta’s
Real-World
Results

Therein
lies
the
problem
for
Sharpe’s
model.

When
the
professor
first
floated
his
concept
in
1964,
nobody
could
refute
it.
The
capital
asset
pricing
model
was
based
on
theory,
not
observation.
In
those
days,
finance
professors
were
few
and
high-powered
computers
rare.
The
research
had
not
been
done
to
assess
whether,
in
fact,
beta had explained
equity
returns.

By
the
time
Sharpe
received
his
Nobel
Memorial
Prize,
that
task
had
been
completed –
and
its
findings
were
devastating.
Concluded
future
Nobel
laureate Eugene
Fama,
who
(along
with Kenneth
French) refuted Sharpe’s
thesis:

“Beta
as
the
sole
variable
in
explaining
returns
on
stocks
is
dead”.

The
wording
was
kind.
Not
only
had
the
authors
discovered
no
link
between
beta
and
stock
performances,
but
they
had
also
shown
value
stocks
had
walloped
growth
stocks.
Less
risk,
more
return!

The
Beta
Field
Test

In
November
1992,
Vanguard
launched
two
style-index
funds,
which
divided
the
S&P
500
into
opposing
segments:
Vanguard
Growth
Index
(VIGRX) and
Vanguard
Value
Index
(VIVAX).
For
the
first
time,
albeit
indirectly
(as
these
investments
were
not
officially
built
to
deliver
high
and
low
betas,
but
they
did
so
in
practice),
observers
could
readily
test
whether
beta
operated
as
advertised.

For
the
first
decade
during
those
funds’
existence,
it
did
not.
As
expected,
Vanguard
Growth
Index’s
beta
was
well
above
that
of
Vanguard
Value
Index.
Its
returns
were
closer
to
the
mark,
but
they
nevertheless
trailed
through
a
mostly
rising
market,
which
(again)
was
not
how
beta
was
supposed
to
work.

After
that
result,
academic
opinion
was
almost
entirely
united.
Another
10
years
of
value-stock
success
confirmed
the
researchers’
initial
suspicions.
Whether
value
stocks
won
because
investors
were
irrationally
wary
of
them,
as behavioural
economists
argued,
or
because
they
carried
meaningful
risks
the
beta
measure
overlooked,
the
reality
had
been
ascertained.
Beta
was
well
and
truly
dead.

Except
that
it
wasn’t.

Since
Vanguard’s
style-index
funds
celebrated
their
10th
birthday,
the
pattern
has
neatly
been
reversed.
Not
each
funds’
beta.
Over
the
next
21
years,
they
remained
almost
unchanged.
Once
again,
Vanguard
Growth
Index’s
beta
surpassed
that
of
Vanguard
Value
Index,
although
the
gap
did
narrow
slightly.
But
the
relative
returns
flipped,
with
Vanguard
Growth
Index
outgaining
its
sibling
by
almost
2
percentage
points
per
year.

Assessing
the
post-1992
record
in
this
fashion,
by
splitting
the
results
into
a
10-year
period
and
then
a
21-year
stretch,
is
of
course
an
arbitrary
decision.
I
did
so
to
demonstrate
how
thoroughly
beta
had
been
discredited
by
the
early
2000s,
when
its
predictive
power
appeared
non-existent.
A
fairer
approach
to
the
data
is
to
avoid
such
tricks
by
presenting
the
31-year
record
in
its
entirety.

The
table
below
does
that,
along
with
showing
the
predicted
return
for
each
fund
per
Sharpe’s
formulation
(which
requires
in
addition
to
the
stock
market’s
results
the
rate
of
risk-free
return,
which
averaged
2.31%
over
the
period).

Final
Thoughts

Few
investment
theories
have
truly
been
validated.
It’s
clear
that,
for
developed
nations
with
healthy
economies,
stocks
will
almost
always
outgain
bonds
over
time.
(That
statement
may
not
necessarily
hold
for
emerging
countries,
a
topic
that
I
will
address
in
a
separate
article.)

No
special
insight
is
required
for
that
observation.
In
June
2003,
a
30-year
Treasury
bond
paid
an
annual
$48.10
(£37.91)
for
each
$1,000
par
value.
It
still
does
today.
Meanwhile,
one
share
of
Microsoft
(MSFT) stock
in
June
2003
earned
the
right
to
$1.37
of
the
company’s
operating
cash
flow.
The
current
amount
is
$11.79.
True,
Microsoft
has
been
unusually
successful,
but
the
principle
remains.
In
aggregate,
companies
grow
their
businesses
rapidly
enough
to
reward
their
shareholders.

After
that,
though,
investment
theory
is
just
that –
a
theory.
The
hypothesis
may
eventually
be
ratified,
but
it
also
could
be
incorrect.
Or,
more
likely,
it
contains
some
truth
but
not
enough
to
serve
as
a
meaningful
predictor.
That
precept
is
worth
considering
the
next
time
a
fund
marketer
presents
an
investment
strategy
that
has
been
“proved”
by
academics.

John
Rekenthaler
is
vice
president
for
research
at
Morningstar

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