Beta Is Overworked and Needs a Rest

Here is a new article about beta and the use of Fundamental indexes at Index Universe.

My own bias is to ignore Beta as it is only moderately interesting. Most people use it to measure results relative to peers or as some silly index. Absolute terminal real wealth appreciation is all that matters.

Beta users tend to be either academics or fund managers calculating who can underperform an index the least. Beta is the vulgar naked cult of fund mediocrity proudly boasting of its sub-par achievements behind the fig leaf of academic groupthink that has gone too far.

Beta gets used too much. It is the mirror image of VAR in terms of the way it is abused as a tool (ie. it reflects a threshold, but really doesn't say much more.) Asset allocation across asset classes is more important in regards to maximizing terminal wealth in real terms. Mean-Variance as a risk-budgeting metric is all but useless.

Consider those lovely CMBS and CDO^2 products that must have had low beta correlations while showing nice low variance. Common sense as a risk metric would have shown the gamma risk inherent in these things better than any statistical ftool. CDO^2 was financial obfuscation taken to new and interesting places.

The cult of correlation has replaced common sense and Beta leads the charge. Correlation and covariance are mirages that vanish quite rapidly providing no solace or liquidity when they are most needed in a portfolio.

The practitioners will of course say the model wasn't robust enough, or the data wasn't there. etc. and up go the cries of "29th Standard deviation events etc.". Quick, blame the Black swans and get back to the modelling.

Rarely does new and interesting equate to better in finance. Financial innovation almost always equates to a few people dreaming up a lexicon and new semantic set to make money for a while followed by many suffering over a longer period of time when those collective beliefs in correlation or co-variance vanish.

If inflation shows up in a meaningful fashion, then Beta will be seen to be wanting as a be-all-end-all metric. In the current equity market, Beta has fallen out of fashion as consumers discover they want absolute and not real returns of course, they still haven't been thinking in Absolute Real returns. Inflation could be the next interesting adjustment to fund metrics.

Ironically, the one place financial managers seem to be comfortable letting go of correlation and co-variance is in the relationship between risk adjusted performance and pay. Pay in finance is still assymetric(sic) and more correlated with peer expectation than the building of real terminal wealth over the long term.

I vote Null on beta. Unfortunately most pension fund managers etc. subscribe to this groupthink and many important institutions will suffer accordingly. The over-allocation to US equities and US debt could become quite an anchor for many, but at least the giant underfunded pensions and institutions will have the salve of correlated misery to sooth and unite their angst.

The only good to come out of the cult of Beta and mean variance risk metrics is that by herding the sheep together, it kept most of them from frequently doing stupid things individually. Instead fund managers get to do stupid things collectively.

Comments

[TATyszka:]

"Beta is the vulgar naked cult of fund mediocrity proudly boasting of its sub-par achievements behind the fig leaf of academic groupthink that has gone too far."

I'm not sure what you said here, but I like it.

: - )

Jun 18 11:13 AM

[Clive Corcoran:]

I'll second the comment above.
There are a lot of intricate ideas in this article which require some thinking about.
One disagreement would be over the point that you make regarding inflation when you say that if it "shows up in a meaningful fashion, then Beta will be seen to be wanting as a be-all-end-all metric."
Surely all portfolio construction techniques would suffer as well.

In the early stages following the failed Armageddon trades of Jan/Feb 09 being long high beta stocks was definitely the place to be. If you wrap together high beta longs with low beta shorts in a nifty package then - with a market that lacks conviction and leadership - Beta is very trader friendly.

Jun 25 08:00 AM