Thursday 16 April 2020

Erratic beta puzzles investors

Many institutional investors had hoped that their defensive, low-beta strategies would weather the corona crisis better than they have. 

The core principle of low-beta strategies is to lose less when the markets take a turn for the worse. However, investors found few places to hide in the sudden equity market drawdown. A new whitepaper published by quant investment boutique Intech analyses the anomalous shift in equity betas across the market in March. 

A stock’s beta is a reasonably stable attribute and typically only changes very slowly over time. This is also referred to as ‘persistency’. It is therefore important to examine why this historical relationship temporarily unraveled. Intech reports that there was a change in the distribution of betas across the equity market. “The significant number of low-beta stocks that underwent a dramatic increase in their betas is a prime example of this shift in distribution. Far fewer stocks at the end of March appeared defensive as measured by this attribute. Stocks that may previously have provided some downside protection were, in some cases, falling even more sharply than the market. And perversely, some were outperforming the market in bear market rallies!”

Another interesting finding was that size mattered. “While low-beta stocks suffered a sudden, substantial sell-off at the end of the first quarter of 2020, the bottom quintile of beta did, in aggregate, outperform the broad index during the quarter. However, even a cursory analysis reveals that this outperformance was not broad-based but concentrated in larger-cap stocks.” In other words, the reason that the aggregated low-beta stocks outperformed the index was due to large-caps. 

How should investors react to these unique circumstances? 

In a conversation with IPE, Nicolas Rabener, founder and CEO of FactorResearch said, “although the low volatility factor, regardless if structured as a long-short or long-only portfolio, has disappointed investors in the coronavirus crisis, it is just one data point and should not be given too much emphasis.”

Intech agrees, urging institutional investors that it is “crucial to be patient during such shifts in market structure and to allow conditions to normalize before reaching potentially rash conclusions. The episodes of breakdown in beta persistence are highly unusual but also tend to be short-lived. We expect beta correlations and distribution to return to their historical relationships eventually.”