Why a High-Beta Stock Portfolio May Not Double Index Returns
Summary
The document examines whether a portfolio of stocks with beta near two should return twice as much as the S&P 500. Under CAPM, a fully diversified portfolio with beta two is expected to earn twice the market risk premium, rather than necessarily twice the market’s total return. A portfolio of a small number of randomly selected high-beta stocks can deviate from that expectation because stock-specific, or idiosyncratic, risk remains and creates tracking error. A leveraged fund tracking the index is suggested as a more direct route to seeking a multiple of index performance.
The discussion also points to evidence that the empirical security market line may be flatter than CAPM predicts. The cited betting-against-beta research reports that high-beta assets can have low alpha and that a strategy long leveraged low-beta assets and short high-beta assets produced positive risk-adjusted returns in the studied markets. These findings qualify the simple CAPM expectation; they do not guarantee future outcomes, and the passage does not detail leverage costs, fund mechanics, or strategy risks.
Key ideas
- CAPM predicts a beta-two diversified portfolio earns twice the market risk premium, not necessarily twice the total index return.
- A concentrated selection of high-beta stocks retains idiosyncratic risk and can diverge from the index.
- An index-tracking leveraged fund is presented as a more direct way to seek amplified index exposure.
- Research cited in the document finds evidence that high-beta assets may have low alpha.
- A betting-against-beta strategy combines leveraged low-beta exposure with short high-beta exposure, but its reported results do not assure future performance.
Tags
Full text
# How to get twice the expected return of S&P 500 # How to get twice the expected return of S&P 500 If I create a diversified portfolio of 2*beta stocks, can I expect to get twice the return of S&P 500. Example: Out of the universe of stocks available to me I randomly choose 10 stocks whose betas are 2. For a year if S&P 500 got 10 %, does that mean I will make 20 % in my portfolio. Reverse is true as well, if S&P made -10 %, I will make -20%. Do these statements make sense ? Thanks. Coder ## Answer by QuantK (score 1, accepted) https://quant.stackexchange.com/a/16327 If you want to obtain 2 times the S&P 500 return, it's safer just buying a leveraged etf tracking the index. Randomly chosing 10 stocks obtaining a 2 beta position can lead to different results. You will have a tracking error due to the leftover idiosyncratic risk ## Answer by fni (score 2) https://quant.stackexchange.com/a/16324 In theory, if you create a fully diversified portfolio with $\beta=2$ you should get 2 times the risk premium on the market. In practice the SML of the CAPM is too flat, meaning that you would be better off buying low beta stocks and shorting high beta stocks. If you don’t trust me read Betting Against Beta by Andrea Frazzini and Lasse Haje Pedersen.They say in the abstract: > We present a model with leverage and margin constraints that vary across investors and time. We find evidence consistent with each of the model's five central predictions: (1) Because constrained investors bid up high-beta assets, high beta is associated with low alpha, as we find empirically for US equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures. (2) A betting against beta (BAB) factor, which is long leveraged low-beta assets and short high-beta assets, produces significant positive risk- adjusted returns. (3) When funding constraints tighten, the return of the BAB factor is low. (4) Increased funding liquidity risk compresses betas toward one. (5) More constrained investors hold riskier assets.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.