What it means
Beta compares how much a share moves compared with a broad market index. A beta of 1.0 means the share moves in line with the market, a beta of 1.5 means it tends to move 1.5 times as much, and a beta below 1.0 means it moves less.
High beta shares often belong to cyclical or fast-growing industries, such as technology, travel or small companies with heavy borrowing. A high beta index selects shares from a larger benchmark based on their betas, and typically holds those with the highest.
The index provider sets the rules for how betas are measured, how many shares are included and how often the list is updated. Funds that track these indices are available, so investors can buy the whole group in one trade.
The attraction is leverage without borrowing. If an investor expects the market to rise, a portfolio of high beta shares should, on average, earn more than the market.
The cost is that the same sensitivity works in reverse during a fall, and losses can be larger than the market's. For businesses and finance teams, beta is also used to estimate the cost of equity, the return that shareholders expect for taking risk.
A company with a high beta has a higher cost of equity, which raises the hurdle rate used to judge new projects. This is why analysts examine the betas of industries when valuing a business.
There are cautions. Beta is calculated from past data and can change, so a share with a high beta last year may not have one next year.
The index also tends to be concentrated in a few sectors, and in a steady rising market it can look brilliant, which encourages investors to ignore the risk until a downturn arrives.
In practice
Real-world examples.
Example
An investor who expects a recovery after a market fall moves part of her portfolio into a fund tracking a high beta index. If the market rebounds 20%, she hopes to gain more than 20% on that portion.
Example
A pension fund trustee reviews the risk of the fund's equity holdings. The analysis shows that the average beta of the portfolio has crept up to 1.3, so the trustee asks the manager to explain why and whether this fits the fund's risk limits.
Example
A corporate finance analyst values a small software company. She uses a beta of 1.6, taken from similar listed firms, which raises the cost of equity and lowers the estimated value compared with using a market-average beta.
Formula
Calculation
Expected return = risk-free rate + beta x (expected market return - risk-free rate)
Suppose the risk-free rate is 4%, the market is expected to return 10% and the index has a beta of 1.5.
Step 1: Market premium = 10% - 4% = 6%.
Step 2: Beta adjustment = 1.5 x 6% = 9%.
Step 3: Expected return = 4% + 9% = 13%.
In a falling market, the same sensitivity applies. If the market drops 10%, a beta of 1.5 suggests a fall of about 1.5 x 10% = 15%, so a $100,000 holding could lose around $15,000 against $10,000 for a market-matching holding.Case study
Seen in the real world.
Windrush Capital is a fictional investment firm that added a high beta fund to its client portfolios during a strong market. The fund returned 24% in a year when the broad market returned 16%, and several clients asked to increase their holdings.
The risk officer reminded the board in this illustrative case that the fund's beta of 1.5 implied a fall of about 30% if the market dropped 20%. The firm capped the holding at 10% of each client's portfolio and showed clients a table of possible gains and losses. When the market later fell 12%, the fund lost about 18%, and clients were not surprised because the possible outcome had been set out.
Watch out
Common mistakes.
- Treating a high beta as the same thing as high quality, when it only describes sensitivity to the market.
- Assuming beta stays constant, when it is estimated from past data and changes over time.
- Buying after a strong run without considering that the index falls faster than the market in downturns.
Questions
People also ask.
What does a beta of 2 mean?
It means the share has tended to move about twice as much as the market, in either direction.
Is a high beta index good for long-term investing?
It can suit investors who understand and can tolerate the larger swings, but it is usually a tactical or minor holding.
How is beta calculated?
It is estimated by comparing a share's returns with market returns over a period, using regression or the ratio of covariance to the market's variance.
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