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What is 'Beta'

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in


comparison to the market as a whole. Beta is used in the capital asset pricing
model (CAPM), which calculates the expected return of an asset based on its beta
and expected market returns. Beta is also known as the beta coefficient.

Calculating 'Beta'
Beta is calculated using regression analysis. Beta represents the tendency of a
security's returns to respond to swings in the market. A security's beta is calculated
by dividing the covariance the security's returns and the benchmark's returns by the
variance of the benchmark's returns over a specified period.

Using Beta
A security's beta should only be used when a security has a high R-squared value in
relation to the benchmark. The R-squared measures the percentage of a security's
historical price movements that could be explained by movements in a benchmark
index. For example, a gold exchange-traded fund (ETF), such as the SPDR Gold
Shares, is tied to the performance of gold bullion. Consequently, a gold ETF would
have a low beta and R-squared in relation to a benchmark equity index, such as the
Standard & Poor's (S&P) 500 Index. When using beta to determine the degree of
systematic risk, a security with a high R-squared value, in relation to its benchmark,
would increase the accuracy of the beta measurement.

Beta is just one useful metric for evaluating a stock's trading tendencies. Here is a
list of the top and bottom 3 Beta stocks in the S&P 500. The list updates daily, so add
stocks to your Watchlist so you can check on their performance, financial metrics
and fundamental indicators.

Highest Beta Stocks in the S&P 500


Add Symbol

FCX
Freeport-McMoRan Inc

CHK
Chesapeake Energy Corp

WMB
Williams Companies Inc
Lowest Beta Stocks in the S&P 500
Add Symbol

FTI
TechnipFMC PLC
FTV
Fortive Corp

ED
Consolidated Edison Inc

Interpreting Beta
A beta of 1 indicates that the security's price moves with the market. A beta of less
than 1 means that the security is theoretically less volatile than the market. A beta of
greater than 1 indicates that the security's price is theoretically more volatile than the
market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than
the market. Conversely, if an ETF's beta is 0.65, it is theoretically 35% less volatile
than the market. Therefore, the fund's excess return is expected to underperform the
benchmark by 35% in up markets and outperform by 35% during down markets.

Many utilities stocks have a beta of less than 1. Conversely, most high-tech, Nasdaq-
based stocks have a beta of greater than 1, offering the possibility of a higher rate of
return, but also posing more risk. For example, as of May 31, 2016, the
PowerShares QQQ, an ETF tracking the Nasdaq-100 Index, has a trailing 15-year
beta of 1.27 when measured against the S&P 500 Index, which is a commonly used
equity market benchmark.

Beta and R-squared


Beta and R-squared are two related, but different measures. A mutual fund with a
high R-squared correlates highly with a benchmark. If the Beta is also high, it may
produce higher returns than the benchmark, particularly in bull markets. R-squared
measures how closely each change in the price of an asset is correlated to a
benchmark. Beta measures how large those price changes are, in relation to a
benchmark. Used together, R-squared and Beta give investors a thorough picture of
the performance of asset managers.

R=squared is a measure of the percentage of an asset or fund's performance as a


result of a benchmark. R squared is reported as a number between 0 and 100. A
hypothetical mutual fund with an R-squared of 0 has no correlation to its benchmark
at all. A mutual fund with an R-squared of 100 matches the performance of its
benchmark precisely.

Beta is a measure of sensitivity to the correlated moves of a benchmark, a fund or


asset. A mutual fund with a Beta of 1.0 is exactly as sensitive, or volatile, as its
benchmark. A fund with a Beta of 0.80 is 20% less sensitive or volatile and a fund
with a Beta of 1.20 is 20% more sensitive or volatile.

Alpha is a third measure, which measures asset managers' ability to capture profit,
when a benchmark is also profiting. Alpha is reported as a number less than, equal
to, or greater than 1.0. The higher a manager's alpha, the greater his or her ability to
profit from moves in the underlying benchmark. Some top-performing hedge fund
managers have achieved short-term Alphas as high as 5 or more using the Standard
& Poor's 500 Index as a benchmark.

The Alpha and Beta of assets with R-squared figures below 50 are thought to be
unreliable because the assets are not correlated enough to make a worthwhile
comparison. A low R-squared or Beta does not necessarily make an investment a
poor choice. It merely means that its performance is statistically unrelated to its
benchmark.

R-Squared
hat is 'R-Squared'
R-squared is a statistical measure that represents the percentage of a fund or
security's movements that can be explained by movements in a benchmark index.
For example, an R-squared for a fixed-income security versus the Barclays
Aggregate Index identifies the security's proportion of variance that is predictable
from the variance of the Barclays Aggregate Index. The same can be applied to
an equity security versus the Standard and Poor's 500 or any other relevant index.

BREAKING DOWN 'R-Squared'


R-squared values range from 0 to 1 and are commonly stated as percentages from 0
to 100%. An R-squared of 100% means all movements of a security are completely
explained by movements in the index. A high R-squared, between 85% and 100%,
indicates the fund's performance patterns have been in line with the index. A fund
with a low R-squared, at 70% or less, indicates the security does not act much like
the index. A higher R-squared value indicates a more useful beta figure. For
example, if a fund has an R-squared value of close to 100% but has a beta below 1,
it is most likely offering higher risk-adjusted returns.

R-Squared Calculation Example


The calculation of R-squared requires several steps. First, assume the following set
of (x, y) data points: (3, 40), (10, 35), (11, 30), (15, 32), (22, 19), (22, 26), (23, 24),
(28, 22), (28, 18) and (35, 6).

To calculate the R-squared, an analyst needs to have a "line of best fit" equation.
This equation, based on the unique date, is an equation that predicts a Y value
based on a given X value. In this example, assume the line of best fit is: y = 0.94x +
43.7

With that, an analyst could compute predicted Y values. As an example, the


predicted Y value for the first data point is:
y = 0.94(3) + 43.7 = 40.88

The entire set of predicted Y values is: 40.88, 34.3, 33.36, 29.6, 23.02, 23.02, 22.08,
17.38, 17.38 and 10.8. Next, the analyst takes each data point's predicted Y value,
subtracts the actual Y value and squares the result. For example, using the first data
point:

Error squared = (40.88 - 40) ^ 2 = 0.77

The entire list of error's squared is: 0.77, 0.49, 11.29, 5.76, 16.16, 8.88, 3.69, 21.34,
0.38 and 23.04. The sum of these errors is 91.81. Next, the analyst takes the
predicted Y value and subtracts the average actual value, which is 25.2. Using the
first data point, this is:

(40.88 - 25.2) ^ 2 = 15.68 ^ 2 = 245.86. The analyst sums up all these differences,
which in this example, equals 763.52.

Lastly, to find the R-squared, the analyst takes the first sum of errors, divides it by
the second sum of errors and subtracts this result from 1. In this example it is:

R-squared = 1 - (91.81 / 763.52) = 1 - 0.12 = 0.88

What is the 'Sharpe Ratio'


The Sharpe ratio is the average return earned in excess of the risk-free rate per unit
of volatility or total risk. Subtracting the risk-free rate from the mean return, the
performance associated with risk-taking activities can be isolated. One intuition of
this calculation is that a portfolio engaging in “zero risk” investment, such as the
purchase of U.S. Treasury bills (for which the expected return is the risk-free rate),
has a Sharpe ratio of exactly zero. Generally, the greater the value of the Sharpe
ratio, the more attractive the risk-adjusted return.

The Sharpe Ratio was developed by Nobel laureate William F. Sharpe.

BREAKING DOWN 'Sharpe Ratio'


The Sharpe ratio has become the most widely used method for calculating risk-
adjusted return; however, it can be inaccurate when applied to portfolios or assets
that do not have a normal distribution of expected returns. Many assets have a high
degree of kurtosis ('fat tails') or negative skewness.

The Sharpe ratio also tends to fail when analyzing portfolios with significant non-
linear risks, such as options or warrants. Alternative risk-adjusted return
methodologies have emerged over the years, including the Sortino Ratio, Return
Over Maximum Drawdown (RoMaD), and the Treynor Ratio.
Modern Portfolio Theory states that adding assets to a diversified portfolio that
have correlations of less than 1 with each other can decrease portfolio risk without
sacrificing return. Such diversification will serve to increase the Sharpe ratio of a
portfolio.

Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio


return

The ex-ante Sharpe ratio formula uses expected returns while the ex-post Sharpe
ratio uses realized returns.

Applications of the Sharpe Ratio


The Sharpe ratio is often used to compare the change in a portfolio's overall risk-
return characteristics when a new asset or asset class is added to it. For example, a
portfolio manager is considering adding a hedge fund allocation to his existing 50/50
investment portfolio of stocks and bonds which has a Sharpe ratio of 0.67. If the new
portfolio's allocation is 40/40/20 stocks, bonds and a diversified hedge fund
allocation (perhaps a fund of funds), the Sharpe ratio increases to 0.87. This
indicates that although the hedge fund investment is risky as a standalone exposure,
it actually improves the risk-return characteristic of the combined portfolio, and thus
adds a diversification benefit. If the addition of the new investment lowered the
Sharpe ratio, it should not be added to the portfolio.

The Sharpe ratio can also help explain whether a portfolio's excess returns are due
to smart investment decisions or a result of too much risk. Although one portfolio or
fund can enjoy higher returns than its peers, it is only a good investment if those
higher returns do not come with an excess of additional risk. The greater a portfolio's
Sharpe ratio, the better its risk-adjusted performance. A negative Sharpe ratio
indicates that a risk-less asset would perform better than the security being
analyzed.

Criticisms and Alternatives


The Sharpe ratio uses the standard deviation of returns in the denominator as its
proxy of total portfolio risk, which assumes that returns are normally distributed.
Evidence has shown that returns on financial assets tend to deviate from a normal
distribution and may make interpretations of the Sharpe ratio misleading.
A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of
upward price movements on standard deviation to measure only return against
downward price volatility and uses the semivariance in the denominator. The Treynor
ratio uses systematic risk or beta (β) instead of standard deviation as the risk
measure in the denominator.

The Sharpe ratio can also be "gamed" by hedge funds or portfolio managers seeking
to boost their apparent risk-adjusted returns history. This can be done by:

 Lengthening the measurement interval: This will result in a lower estimate of volatility.
For example, the annualized standard deviation of daily returns is generally higher
than that of weekly returns, which is, in turn, higher than that of monthly returns.

 Compounding the monthly returns but calculating the standard deviation from
the not compounded monthly returns.

 Writing out-of-the-money puts and calls on a portfolio: This strategy can potentially
increase return by collecting the option premium without paying off for several years.
Strategies that involve taking on default risk, liquidity risk, or other forms of
catastrophe risk have the same ability to report an upwardly biased Sharpe ratio. An
example is the Sharpe ratios of market-neutral hedge funds before and after
the 1998 liquidity crisis.)

 Smoothing of returns: Using certain derivative structures, infrequent marking to


market of illiquid assets, or using pricing models that understate monthly gains or
losses can reduce reported volatility.

 Eliminating extreme returns: Because such returns increase the reported standard
deviation of a hedge fund, a manager may choose to attempt to eliminate the best
and the worst monthly returns each year to reduce the standard deviation.

What is the 'Treynor Ratio'


The Treynor ratio, also known as the reward-to-volatility ratio, is a metric for returns
that exceed those that might have been gained on a risk-less investment, per each
unit of market risk. The Treynor ratio, developed by Jack Treynor, is calculated as
follows:

(Average Return of a Portfolio – Average Return of the Risk-Free Rate)/Beta of the


Portfolio

BREAKING DOWN 'Treynor Ratio'


In essence, the Treynor ratio is a risk-adjusted measurement of a return, based
on systematic risk. It is a metric of efficiency that makes use of the relationship that
exists between risk and annualized risk-adjusted return.

Sharpe Ratio
The Treynor ratio shares similarities with the Sharpe ratio. The difference between
the two metrics is that the Treynor ratio utilizes beta, or market risk, to measure
volatility instead of using total risk (standard deviation).

How the Treynor Ratio Works


Ultimately, the ratio attempts to measure how successful an investment is in
providing investors compensation, with consideration for the investment’s inherent
level of risk. The Treynor ratio is reliant upon beta – that is, the sensitivity of an
investment to movements in the market – to judge risk. The Treynor ratio is based on
the premise that risk inherent to the entire market (as represented by beta) must be
penalized, because diversification will not remove it.

When the value of the Treynor ratio is high, it is an indication that an investor has
generated high returns on each of the market risks he has taken. The Treynor ratio
allows for an understanding of how each investment within a portfolio is performing.
It also gives the investor an idea of how efficiently capital is being used.

Limitations
The Treynor ratio does not include any added value gained from active portfolio
management. It is simply a ranking criterion. A list of portfolios ranked based on the
Treynor ratio is useful only when considered portfolios are actually sub-portfolios of a
larger, fully diversified portfolio. Otherwise, portfolios with varying total risk, but
identical systematic risk, will be ranked or rated exactly the same.

Another weakness of the Treynor ratio is its backward-looking nature. Investments


will almost inevitably perform differently in the future than they did in the past. For
example, a stock carrying a beta of 2 will not typically be twice as volatile as the
market indefinitely. By the same token, a portfolio can’t be expected to generate 12%
returns over the next decade all because it generated 12% returns over the last 10
years.

What is the 'Jensen's Measure'


The Jensen's measure is a risk-adjusted performance measure that represents
the average return on a portfolio or investment above or below that predicted by
the capital asset pricing model (CAPM) given the portfolio's or investment's beta and
the average market return. This metric is also commonly referred to as Jensen's
alpha, or simply alpha.

BREAKING DOWN 'Jensen's Measure'


To accurately analyze the performance of an investment manager, an investor must look not
only at the overall return of a portfolio, but also at the risk of that portfolio to see if the
investment's return compensates for the risk it takes. For example, if two mutual funds both
have a 12% return, a rational investor should prefer the fund that is less risky. Jensen's
measure is one of the ways to determine if a portfolio is earning the proper return for its level
of risk. If the value is positive, then the portfolio is earning excess returns. In other words, a
positive value for Jensen's alpha means a fund manager has "beat the market" with his
stock picking skills.

Jensen's Measure Calculation Example


Assuming the CAPM is correct, Jensen's alpha is calculated using the following four
variables:

R(i) = the realized return of the portfolio or investment

R(m) = the realized return of the appropriate market index

R(f) = the risk-free rate of return for the time period

B = the beta of the portfolio of investment with respect to the chosen market index

Using these variables, the formula for Jensen's alpha is:

Alpha = R(i) - (R(f) + B x (R(m) - R(f)))

For example, assume a mutual fund realized a return of 15% last year. The
appropriate market index for this fund returned 12%. The beta of the fund versus that
same index is 1.2 and the risk-free rate is 3%. The fund's alpha is calculated as:

Alpha = 15% - (3% + 1.2 x (12% - 3%)) = 15% - 13.8% = 1.2%.

Given a beta of 1.2, the mutual fund is expected to be riskier than the index, and
thus earn more. A positive alpha in this example shows that the mutual fund
manager earned more than enough return to be compensated for the risk he took
over the course of the year. If the mutual fund only returned 13%, the calculated
alpha would be -0.8%. With a negative alpha, the mutual fund manager would not
have earned enough return given the amount of risk he was taking.

What is a 'Tracking Error'


Tracking error is the divergence between the price behavior of a position or a
portfolio and the price behavior of a benchmark. This is often in the context of
a hedge or mutual fund that did not work as effectively as intended, creating
an unexpected profit or loss instead.

Tracking error is reported as a standard deviation percentage difference,


which reports the difference between the return an investor receives and that
of the benchmark he was attempting to imitate.

BREAKING DOWN 'Tracking Error'


Since portfolio risk is often measured against a benchmark, tracking error is a
commonly used metric to gauge how well an investment is performing.
Tracking error shows an investment's consistency versus a benchmark over a
given period of time. Even portfolios that are perfectly indexed against a
benchmark behave differently than the benchmark, even though this
difference on a day-to-day, quarter-to-quarter or year-to-year basis may be
ever so slight. Tracking error is used to quantify this difference.

Calculation of Tracking Error


Tracking error is the standard deviation of the difference between the returns
of an investment and its benchmark. Given a sequence of returns for an
investment or portfolio and its benchmark, tracking error is calculated as
follows:

Tracking Error = Standard Deviation of (P - B).

For example, assume that there is a large cap mutual fund that is
benchmarked to the Standard and Poor's (S&P) 500 index. Next, assume that
the mutual fund and the index realized the follow returns over a given five-year
period:

Mutual Fund: 11%, 3%, 12%, 14% and 8%.

S&P 500 index: 12%, 5%, 13%, 9% and 7%.

Given this data, the series of differences is then (11% - 12%), (3% - 5%), (12%
- 13%), (14% - 9%) and (8% - 7%). These differences equal -1%, -2%, -1%,
5%, and 1%. The standard deviation of this series of differences, the tracking
error, is 2.79%.

Interpretation of Tracking Error


If you make the assumption that the sequence of return differences is normally
distributed, you can interpret tracking error in a very meaningful way. In the
above example, given this assumption, it can be expected that the mutual
fund will return within 2.79%, plus or minus, of its benchmark approximately
every two years out of three.

From an investor point of view, tracking error can be used to evaluate portfolio
managers. If a manager is realizing low average returns and has a large
tracking error, it is a sign that there is something significantly wrong with that
investment and that the investor should most likely find a replacement.
What is the 'Sortino Ratio'
The Sortino ratio is a variation of the Sharpe ratio that differentiates
harmful volatility from total overall volatility by using the asset's standard
deviation of negative asset returns, called downside deviation. The Sortino
ratio takes the asset's return and subtracts the risk-free rate, and then divides
that amount by the asset's downside deviation. The ratio was named after
Frank A. Sortino.

BREAKING DOWN 'Sortino Ratio'


The Sortino ratio is a useful way for investors, analysts and portfolio
managers to evaluate an investment's return for a given level of bad risk.
Since this ratio uses the downside deviation as its risk measure, it addresses
the problem of using total risk, or standard deviation, as upside volatility is
beneficial to investors.

A ratio such as the Sharpe ratio punishes the investment for good risk, which
provides positive returns for investors. However, determining which ratio to
use depends on whether the investor wants to focus on standard deviation or
downside deviation.

Sortino Ratio Calculation Example


Just like the Sharpe ratio, a higher Sortino ratio is better. When looking at two
similar investments, a rational investor would prefer the one with the higher
Sortino ratio because it means that the investment is earning more return per
unit of bad risk that it takes on. The formula for the Sortino ratio is as follows:

Here, R equals the asset's or portfolio's annualized return, r(f) equals the risk-
free rate, and DD equals the asset's or portfolio's downside deviation.

For example, assume Mutual Fund X has an annualized return of 12% and a
downside deviation of 10%. Mutual Fund Z has an annualized return of 10%
and a downside deviation of 7%. The risk-free rate is 2.5%. The Sortino ratios
for both funds would be calculated as:

Mutual Fund X Sortino = (12% - 2.5%) / 10% = 0.95


Mutual Fund Z Sortino = (10% - 2.5%) / 7% = 1.07

Even though Mutual Fund X is returning 2% more on an annualized basis, it is


not earning that return as efficiently as Mutual Fund Z, given their downside
deviations. Based on this metric, Mutual Fund Z is the better investment
choice.

While using the risk-free rate of return is common, investors can also
use expected return in calculations. To keep the formulas accurate, the
investor should be consistent in terms of the type of return.

For an in-depth knowledge of this ratio, read Mitigating Downside With the
Sortino Ratio and 5 Ways to Rate Your Portfolio Manager.

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