Beta and Risk in Troubled Markets, Part 2

Fri, Jan 16, 2009 | Jared Woodard


In this mini-series, we’re examining the value of beta as a measurement of risk.  In this post, we want to examine how the betas of some popular stocks, indexes, and ETFs changed during 2008 and especially during the fall crash.  First, we should clarify exactly what we’re measuring.

What is beta?

Beta is metric that describes the systemic risk of an asset or portfolio.  Because it is not possible to alleviate all risk by simple diversification, investors and traders use beta to determine how much exposure they have to broad market risk – how closely their expected returns correlate with broad market returns.  Where a market index is assigned a beta of 1, assets with betas of 1 will tend to move with the market, assets with betas of 2 will tend to rise or fall twice as much as the market, and assets will betas of 0 will tend to move independently.

We calculate beta as the ratio of the covariance of the individual asset return (Ri) and market return (Rm) to the variance of the market return:

We use the S&P 500 (SPX) for the market returns.  Notice that beta describes a tendency, not a law: if the S&P 500 rises 2% tomorrow but some stock with a beta of 1.5 rises only 2.5% (rather than 3%), that one data point isn’t significant in itself – what matters is the relationship between returns over time.  [Note that in Excel, the function VARP should be used rather than VAR; the latter returns a benchmark beta of less than 1.]

Beta over Time

The following graph displays the beta of all of the assets mentioned in Part 1: 1) based on monthly returns over the years 1997-2007, 2) based on daily returns during 2008, and 3) based on daily returns during 9/15/08 – 12/2/08, which we’re defining as the “market crash” period. [Note: XLF and XLE were listed in January 1999; SSO in June 2006.]

There are few surprises here, actually:

  • Apple (AAPL), General Electric (GE), the Russell 2000 (RUT), and the Nasdaq 100 (NDX) all exhibited variance in line with the market in general during 2008 as well as during the “crash” period, even though they had previously been less correlated.
  • Consumer “safety” stocks stayed safe: Wal-Mart (WMT) and Campbell Soup (CPB) actually moved more independently during the crash than their monthly long-term betas would’ve suggested.  Of course, beta should not be confused with performance: CPB’s relative stability during October was little consolation to investors who jumped in and took a beating in November-December.  Again, by “safety,” we just mean reducing correlation to market returns.
  • Commodities became more correlated: as evident in U.S. Steel (X) and the Energy Select SPDR (XLE), exposure to commodities was not a very effective market hedge last year.  X, which used to be a Dow-30 component, behaved more like a 2x S&P fund than anything else.
  • Financials (WFC, XLF) saw dramatically higher betas – no surprise there, as they were at the heart of the crisis.

How did the double-shot S&P ETF fare?

  • SSO, the Ultra S&P Proshares fund, is designed to track twice the daily performance of the S&P 500.  That means it is explicitly designed to have a beta of 2.  Strangely enough, since inception it has succeeded in that task, with a beta of 2.0028 calculated based on monthly returns.  During 2008, its beta based on daily returns was closer to 1.85, and dropped to 1.83 during the crash period.  That may not sound like a lot, but it could have significant (and disappointing) consequences for anyone trading it as a portfolio hedge over the short term.

Overall, the maxim that “during a crisis, all betas go to one” seems only provisionally correct: while some stocks abandoned their long-term monthly betas to mimic the market more closely during the 2008 crash and the year in general, fundamentals drove poor performers in energy and finance to act more like leveraged market trackers, even as traditional safe havens retained that characteristic.  We aren’t fundamental investors, so this is admittedly just an ad hoc snapshot, and a sector-by-sector review would give a more accurate picture.

In the next part of this series, we’ll look at how a portfolio consisting of the six stocks above (AAPL, GE, X, WFC, WMT, CPB) and a beta-adjusted delta hedge would have fared during 2008 and the fall turmoil in particular.

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  1. January Monthly Review | Condor Options Says:

    [...] and Risk in Troubled Markets (Part 1, Part 2) SHARETHIS.addEntry({ title: “January Monthly Review”, url: [...]


Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More


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