We are not the first to recognize this relationship between historical and realized betas. It has appeared in some prior academic research and clearly the team at Bloomberg recognized it. In all fairness, Bloomberg’s adjustment does appear to improve overall accuracy and we did not test its efficacy as a pricing model (in testing CAPM returns, for example). But it is surprising to us that traditional beta estimates are still widely used and interpreted the same way. To address the question from above, if the market went up 10% this quarter, the stock with a beta of 1.30 would probably not be up 30% more than the market (13%). In fact, a return closer to 15-20% greater would be more likely based the observed reversion of higher betas towards 1.0.

This built-in mean reversion in the traditional beta estimates raises some larger questions. There is a body of research supporting the existence of a “low beta anomaly” demonstrating that lower volatility stocks have both higher returns (and lower risk) in comparison to higher volatility stocks (see references below for more information). Yet according to the original portfolio theory dating back to Markowitz (1952), there is supposed to be a positive relationship between risk and return.

How much of this anomaly is driven by a fundamentally flawed estimate of future beta? If the traditional methods under-estimate low betas and over-estimate high betas, a strategy of buying the low beta and selling the high beta would be a way to profitably play the reversion to the mean (or towards 1.0 in this case). But if you had a better forecast of future beta, how does that change the dynamic?

This is exactly the question we looked to address in developing truBeta and founding Salt Financial. In future posts, we will delve into more of the details behind our process of using a more accurate forecast of beta to build portfolio construction tools.

This article was republished with permission from Salt Financial.

Bibliography

“Risk, Return, and Equilibrium: Empirical Tests”, Eugene F. Fama and James D. MacBeth, The Journal of Political Economy , vol. 81, no 3 (May-June 1973) 607-636

“Risk and Rate of Return on Financial Assets: Sold Old Wine in New Bottles”, Robert A. Haugen and A. James Heins, Journal of Financial and Quantitative Analysis , vol. 10, no 5 (December 1975) 775-784

“The Cross-Section of Volatility and Expected Returns”, Andred Ang, Robert J. Hodrick, Yuhan Xing, and Xiaoyan Zhang, Journal of Finance , vol. 61, no. 1 (February 2006) 259-299 and “High Idiosyncratic Volatility and Low Returns: International and Further US Evidence”, Journal of Financial Economics , vol. 91, no. 1 (January 2009) 1-23

“The Low Volatility Anomaly: Market Evidence on Systematic Risk vs. Mispricing”, Xi Li, Rodney N. Sullivan, CFA, and Luis Garcia-Fiejóo, CFA, CIPM, Financial Analysts Journal, vol. 72, no. 1 (January/February 2016) 36-47 ©2018 Salt Financial LLC is a registered investment adviser. The information provided herein is for information purposes only and is not intended to be and does not constitute financial, investment, tax or legal advice. Investment advice can be provided only after a properly executed investment advisory agreement has been entered into by the client and Salt Financial LLC (“Salt”). All investments are subject to risks, including the risk of loss of principal. Past performance is not an indicator of future results.

The information and opinions contained in Salt’s blog posts, market commentaries and other writings are of a general nature and are provided solely for the use of Salt, its clients and prospective clients. This content is not to be reproduced, copied or made available to others without the expressed written consent of Salt. These materials reflect the opinion of Salt on the date of production and are subject to change at any time without notice. Due to various factors, including changing market conditions or tax laws, the content may no longer be reflective of current opinions or positions.

Any market observations and data provided are for informational purposes only. Where data is presented that is prepared by third parties, such information will be cited, and these sources have been deemed to be reliable. However, Salt does not warrant the accuracy of this information. Salt and any third parties listed, cited or otherwise identified herein are separate and unaffiliated and are not responsible for each other’s policies, products or services.

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