The Use of Beta in Stocks and ETFs: An Understanding
The term “beta” is widely used in the financial industry to describe how volatile an investment is in comparison to the market. In this post, we will get to know the beta of ETFs and stocks.
Investors need to understand beta because it helps them make decisions by letting them know the potential benefits and dangers of a particular investment. In this blog, we will examine what beta is, how it functions, and how it affects investors.
Describe Beta
An ETF’s or stock’s beta value reveals how volatile it is in relation to the market. It is customary to use a benchmark index, such as the S&P 500, to reflect the market.
Also see: What is the S&P 500 and How Does Its Rebalancing Work?
A stock or exchange-traded fund (ETF) with a beta of one is expected to move exactly in line with the market.
A stock or ETF is expected to have lower volatility than the market if
The beta is less than 1, which would lead to smaller gains or losses.
How to Calculate Beta
The returns of the stocks or ETFs and the returns of the benchmark index are the two variables in this scenario, where covariance is a measure of the correlation between two variables and variance is a measure of the dispersion of a group of data points.
Beta extrapolates past performance to predict future volatility because it is a forward-looking indicator. It is a tool to aid investors in making wise selections, rather than a promise of future performance.
Investor Impacts of Beta
Since beta displays an investment’s risks and returns, it has significant implications for investors.
A stock or ETF with a greater beta is riskier since it is more erratic than the market. It also implies that the stock or ETF may offer greater returns. This is because exchange-traded funds (ETFs) and stocks with higher beta are more susceptible to market volatility and thus more likely to see sizable gains or losses.
Less beta, less risk
A stock or ETF with a smaller beta, on the other hand, is thought to be less risky because it is thought to be less volatile than the market.
Controlling gain and risk
By enabling users to gauge the possible volatility of an investment and make wise selections, beta gives investors a way to balance risk and profit. A risk-tolerant investor could prefer investments with higher betas, whereas a risk-averse investor might select stocks or ETFs with lower betas.
To reduce the total beta of their portfolio, an investor can, for instance, add securities such as consumer staples, utilities, or ETFs with lower betas. On the other hand, a trader who wants to increase the overall beta of the portfolio can add businesses or ETFs with higher betas, including those in the biotechnology or technology industries.
It is critical to keep in mind that beta should not be the primary factor when creating a portfolio.
Beta is a forward-looking indicator that only provides an estimate of future volatility based on historical performance, so it is crucial to keep that in mind as well. A stock’s or ETF’s beta may alter over time because the market is always shifting.
High-beta stocks often have more volatility since they are more susceptible to market changes. They are prone to considerable price fluctuations because of both positive and negative market movements. High-beta stocks may have the potential for greater returns during a bull market, but they also carry higher risks and could suffer significant losses during a bear market.
Investors who are interested in high-beta equities should be aware of the higher risks associated with these types of investments. High-beta equities may trade more erratically and be vulnerable to jarring price movements, which might lead to higher volatility and possibly bigger losses.
When assessing these kinds of investments, there are a few more factors to take into account in addition to the risks and potential benefits related to high-beta stocks:
High-beta stocks are frequently concentrated in industries such as technology, biotech, or consumer discretionary. Due to their concentration, these stocks may be more volatile during market downturns or changes in industry sentiment.
Market Cycles: In bull markets, when the market as a whole is gaining, high-beta stocks typically do better. They may, however, underperform in downturns or times of market turmoil. Therefore, timing is crucial when buying high-beta stocks.
Diversification: High-beta stocks can be riskier than lower-beta stocks due to their increased volatility. As a result, portfolio diversification is crucial to lowering the risk of significant losses. This entails buying a variety of equities with high and low beta values, as well as other asset classes like bonds, real estate, and cash.
Company Fundamentals: Prior to making an investment in a company’s stock, it is crucial to consider the underlying fundamentals of the organization. This comprises elements like revenue growth, profitability, and the caliber of the management. Strong company fundamentals can help lower risk and raise the possibility of long-term growth, even though high-beta companies may be more volatile.
In general, high-beta stocks might be a desirable investment choice for people who are willing to take on more risk. Before investing in these kinds of stocks, it’s crucial to take into account the risks, timing, diversification, and company fundamentals.
Some of the most popular extremely high-beta ETFs in 2024
TQQQ: TQQQ has a beta of 3.5. This ETF offers 3x daily long leverage to the NASDAQ-100 Index, making it a powerful tool for investors with a bullish short-term outlook for nonfinancial equities.
SOXL: SOXL has a beta of 3.92. This ETF offers three times daily long leverage to the PHLX Semiconductor Index, making it a powerful tool for investors with a bullish short-term outlook for semiconductor equities.
XOP: XOP has a beta of 2.06; this ETF offers exposure to the exploration and production sub-sector of the domestic energy market, making it a potentially useful tool for those looking to target stocks of companies responsible for discovering and accessing new deposits of oil and gas.
One must know that high-beta ETFs are extremely risky and volatile. They can go up and down by a similar percentage, depending on market sentiment.
Below is a link to higher-beta ETFs.
https://etfdb.com/etfs/investment-style/high-beta/
Some of the most popular extremely low-beta ETFs in 2024 are:
BND: BND is a benchmark for the bond market. It has a beta of 1.0. This popular ETF offers exposure to the entire investment-grade bond market in a single ticker, with holdings in T-Bills, corporates, MBS, and agency bonds.
GLD: GLD has a beta of 0.10. GLD is one of the most popular ETFs in the world, offering exposure to an asset class that has become increasingly important to the asset allocation process in recent years.
BNDX: BNDX has a beta of 0.79. The Total International Bond Index Fund seeks to track the performance of a US dollar-hedged benchmark index that measures the investment return of investment-grade bonds issued outside of the United States.
Below is a link to lower-beta ETFs.
https://etfdb.com/etfs/investment-style/low-beta/
A negative beta ETF is an exchange-traded fund that has a negative beta coefficient. Beta is a measure of a stock’s or ETF’s sensitivity to changes in the overall market. A beta of 1 indicates that the stock or ETF moves in line with the market, while a beta of less than 1 suggests that it is less volatile than the market. A negative beta indicates that the stock or ETF moves in the opposite direction of the market.
Negative beta ETFs are designed to provide investors with a hedge against market downturns. These ETFs typically invest in assets that tend to rise in value when the market falls, such as bonds, gold, or other commodities. By investing in a negative beta ETF, investors can potentially offset losses in their portfolio during market downturns.
It’s important to note that negative beta ETFs may not always perform as expected. Interest rates, inflation, and geopolitical events are just a few of the variables that can affect them. Additionally, negative beta ETFs may have higher expenses and lower liquidity compared to more traditional ETFs, which can impact their overall performance and risk profile.
As with any investment, it’s important for investors to carefully consider their investment goals and risk tolerance before investing in negative beta ETFs or any other investment product.
Here are some examples of negative beta ETFs.
SH: SH has a negative beta around -0.98. This ETF offers inverse exposure to an index comprised of large-cap U.S. equities, making it a potentially attractive option for investors looking to bet against this sector of the U.S. economy.
SDOW: SDOW has a negative beta around -2.59. This ETF offers 3x daily short leverage to the Dow Jones Industrial Average, making it a powerful tool for investors with a bearish short-term outlook for large-cap U.S. equities.
SQQQ: SQQQ has a negative beta of around -3.52. This ETF offers 3x daily short leverage to the NASDAQ-100 Index, making it a powerful tool for investors with a bearish short-term outlook for nonfinancial equities.
A negative beta stock is a stock that has a negative beta coefficient. Beta is a measure of a stock’s sensitivity to changes in the overall market. A beta of 1 indicates that the stock moves in line with the market, while a beta of less than 1 suggests that it is less volatile than the market. A negative beta indicates that the stock moves in the opposite direction of the market.
Negative beta stocks are considered defensive stocks because they tend to perform well when the market is in a downturn. Examples of negative beta stocks include consumer staples, utilities, and healthcare stocks. These types of stocks are typically less cyclical and more stable than other stocks, which makes them attractive to investors during uncertain economic times.
It’s worth noting that negative beta stocks may not always perform as expected. Interest rates, inflation, and geopolitical events are just a few of the variables that can affect them. Additionally, negative beta stocks may have lower returns than more growth-oriented stocks during periods of market growth.
As with any investment, it’s important for investors to carefully consider their investment goals and risk tolerance before investing in negative beta stocks or any other investment product.
Alpha and beta are two important concepts used to evaluate the performance and risk of investments, including ETFs (exchange-traded funds) and individual stocks. Here’s the difference between the two:
- Alpha measures the excess return of an investment (ETF or stock) relative to a benchmark index, such as the S&P 500.
- It represents the investment’s ability to generate returns that are independent of market movements.
- A positive alpha indicates that the investment outperformed its benchmark, while a negative alpha suggests underperformance.
- Alpha is used to assess the skill of a fund manager or an investor in generating superior returns above what would be expected given the risk taken.
To understand alpha better, let’s break it down:
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Benchmark: A benchmark is a standard or reference point against which the performance of an investment is compared. Common benchmarks include major stock market indices like the S&P 500, Dow Jones Industrial Average, or Nasdaq Composite.
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If an investment outperforms its benchmark, it generates a positive alpha (alpha > 0). If it underperforms the benchmark, it has a negative alpha (alpha < 0).
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Alpha: Alpha is a quantitative measure that represents the investment’s outperformance or underperformance relative to its benchmark. It indicates the investment manager’s ability to generate returns independent of market movements. Positive alpha suggests that the investment outperformed the benchmark, while negative alpha indicates underperformance.
While considering investing in an ETF or stock, one must look at many things besides its alpha and beta. One needs to know its total assets under management, daily trading volume, top holdings, and most importantly, its long-term performance history going back 10–15 years for that particular fund. So do your homework before investing.
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