Seeking Refuge From Market Turbulence With Low Beta Opportunities: Part 1

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 |  Includes: ED, EMB, GLD, LQD, PCG, PCY, SPY, VDC, XLP, XLU
by: Bennington Investment Ideas

The S&P 500 has become increasingly volatile over the past several months. Increasing uncertainty about economic conditions across the globe have resulted in rapidly fluctuating stock prices. I've noted in earlier articles that global equity markets have become increasingly correlated, hence, the one-time refuge of foreign stocks, even emerging markets, is no longer available.

The SPDR S&P 500 trust ETF (NYSEARCA:SPY) has shown an up-tick in volatility. Over the past 3 years, its monthly volatility was 5.3% while over the past 3 months it has ticked up to 6.3%. Beta measures the level of market exposure for a given security. A high beta is often used as shorthand for a risky or growth stock, while a low beta is traditionally associated with "safer" stocks, such as utilities. Gold is typically not correlated to the market as a whole and hence has a beta around 0. Betas can range from across the spectrum; however, it is rare to see one below -1 or above 4. The market has a beta of 1 by definition. In mathematical terms, beta is the ratio of the covariance of the market's returns and security's returns to the variance of the market's return. However, this does not really provide any intuition around beta. Rearranging the mathematical terms gives beta to be the product of two numbers:

  1. The ratio of the security's volatility to that of the market's volatility
  2. The correlation of the security's returns to the market's return

Hence in these terms, a low beta might be low because it has a very low correlation or a very low volatility. There is a possibility that a low correlation could offset a relatively high volatility. This is a less ideal situation, especially for investors looking for a good night's sleep. So the goal is to not just find low beta, but find low beta that is from a low correlation coefficient and a low relative volatility. There are several options for looking for low beta opportunities:

1. Utilities - Utilities typically offer attractive dividends and low risk. Their often regulated rates of return insulate them from market turbulence and provide predictable results. Since regulated utilities make their money from allowed rates of return on their rates base, essentially assets, it is important to look for utilities with expanding rate bases, which will be driven by growth in population and economic activity. One way to gain broad utility exposure is through the SPDR Sector Select Utility ETF (NYSEARCA:XLU). XLU has $6.6 billion in assets and currently yields 4.0% based on a trailing twelve months of $1.35 and a closing price of $33.98. Specific utilities to consider include PG&E Corp. (NYSE:PCG) and Consolidated Edison, Inc.(NYSE:ED). PCG has a market capitalization of $17.0 billion and currently yields 4.3% based on a trailing twelve months of $1.82 and a closing price of $42.50. ED has a market capitalization of $16.9 billion and currently yields 4.2% based on a forward estimated dividend of $2.415 and a closing price of $57.55. It should be noted that there are other utilities with higher dividend yields; however, these two were selected for their low betas.

2. Investment Grade Corporate Bonds - Investment grade corporate bonds are often insulated from market fluctuations due to their position in a company's capital structure. While they are the first to get paid, they also typically offer lower rates of return in exchange for this security. One way to gain exposure is through iShares iBoxx $ Invest Grade Corp Bond (NYSEARCA:LQD). LQD has $14.8 billion in assets and currently yields 4.6% based on a trailing twelve months of $5.101 and a closing price of $111.74.

3. Emerging Market Bonds - While emerging markets equity investments might have lost some of their diversification benefits, emerging market bond funds continue to offer opportunities for investors. However, not all funds are the same nor do they provide the same level of diversification. Two possible options are iShares JPMorgan USD Emerging Markets Bond (NYSEARCA:EMB) and PowerShares Emerging Markets Sovereign Debt (NYSEARCA:PCY). PCY has $1.3 billion in assets under management and currently yields 5.6% based on a trailing twelve months of $1.492 and a closing price of $26.88. EMB has about $3.1 billion in assets and currently yields 5.0% based on a trailing twelve months of $5.358 and a closing price of $107.76.

4. Precious metals - Precious metals like gold and silver have long been a haven for investors seeking assets with lower market correlations. Exposure can be obtained through physical or paper exposure. However, transaction costs might be substantially higher with gold coins or bullion, similar to silver. One can get exposure through SPDR Gold Shares (NYSEARCA:GLD) or ETFS Physical Silver Shares (NYSEARCA:SIVR). GLD has $71.8 billion in assets and does not pay a dividend.

5. Consumer Staples ETFs - Consumer staples are often viewed as defensive stocks since consumers purchase their goods regardless of the economic situation. Two ways to obtain exposure to the consumer staples segment: through the Consumer Staples Select Sector SPDR (NYSEARCA:XLP) and Vanguard Consumer Staples ETF (NYSEARCA:VDC). XLP has $5.1 billion in assets and currently yields 2.8% based on a trailing twelve months of $0.856 and a closing price of $30.87. VDC has just $820 million in assets and yields 2.4% based on a trailing twelve months of $1.906 and a closing price of $79.27. It should be noted that VDC only pays an annual dividend in December.

These are five areas to begin looking for opportunities with low beta. The following table shows which securities offer both a low correlation and a low volatility.

Betas of Select Securities

Ticker Correlation to SPY Monthly Volatility Volatility Ratio Implied Beta
SPY 100% 4.5% 1.00 1.00
LQD 12% 1.5% 0.34 0.04
ED 27% 3.0% 0.65 0.18
GLD 15% 5.4% 1.19 0.18
PCY 45% 2.3% 0.50 0.23
EMB 49% 2.1% 0.46 0.23
PCG 33% 3.6% 0.79 0.26
XLU 58% 2.9% 0.64 0.37
XLP 86% 3.0% 0.66 0.56
VDC 87% 3.0% 0.66 0.58
Click to enlarge

Source: Yahoo!Finance, author calculations. Metrics are based on a 30-month time frame. One should note that the 30-month volatilities are much lower than the 36-month volatility since the 30-month window now excludes the market turbulence from the fall of 2008 to the spring of 2009.

The first observation is that not all securities with low betas have low correlations nor do they have low volatilities. GLD has one of the lowest betas, but this is due to its near zero correlation. It is actually more volatile than the market as a whole. Furthermore, consumer staples show a relatively high correlation to the market, but have comparable volatilities to XLU. In terms of attractiveness, it appears that PCY and EMB offer a good balance of low beta, low volatility, and good current income.

However, when looking at beta to evaluate an investment opportunity it is important to consider it as a stand-alone investment. Finding an investment that has a low beta is not much use if the price of it collapses after you invest. A reasonable approach would be to look at the universe of low beta investing opportunities and then seek out individual securities with reasonable valuations and attractive fundamentals.

It should also be noted that this is not comprehensive of all types of opportunities. Part 2 will look at another set including real estate, specific stocks, and other investments.

Disclosure: I am long SPY.


Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Continue to Part 2 >>