Batting for Beta: The Supporting Evidence

Batting for Beta: The Supporting Evidence

Tesis of the capital-asset pricing model have tried to ascertain if security returns are in fact directly related to beta, as the theory asserts, we have already presented some data on this question. Here we would like to present some additional evidence.

The enthusiasm for beta and for the CAPM in which it is wrapped has been fueled by charts, such as the chart that show the relationship over a twenty-year period between the performance of a large number of professionally managed funds and the beta measure of relative volatility.  It is because the numbers are averages of many funds that the relationship between risk and reward is so tight. Still, the results appear to be quite consistent with the theory. The portfolio returns have varied positively with in (almost) a straight0line manner, so that over the long pull, high-beta portfolios have provided larger total returns than low-risk ones.

The relationship is exactly as predicted by the theory. In “up” years, the high-beta portfolios well outdistanced the low-beta ones. It was the high-beta portfolios that took the real drubbings in the bear-market periods of the 1970s. Of course, this is precisely what we mean by the concept of risk, and this is why betas for diversified portfolios appear to be useful risk measures.

The possibility of obtaining higher returns over the long pull from higher-beta portfolios is perfectly consistent with the random-walk and efficient-market notions. The efficient-market theory asserts that there is no way to gain superior performance (that is, extra returns) for a given level of risk. The beta advocates say that the only way to gain extra returns is to take on more risk. But this is hardly an inefficiency in the market. It is the natural expectation in a market where most participants dislike risk and therefore must be compensated (reawarded) to bear it.

Batting for beta... Photo by Elena

Being Bearish on Beta: Some Disquieting Results

Like just about everything in life, beta may work well some of the time, but it certainly doesn't live up to its press billings all of the time. Burrowing away at the statistical base of the capital-asset pricing model, the beta bears have uncovered major flaws. The evidence contradicting this fundamental part of the new investment technology has sent some practitioners and academics off in search of ways to improve the CAPM. And even some institutional investors who in the past swore by the model began disavowing it altogether by the late 1980s. In order to understand this reaction, we need to examine the academic studies that led to beta's fall from grace, at least in the minds of some academics and professionals.