Managerial Finance

Case: Beta Management

Beta Management company

Key facts

Small investment management company Located in a Boston suburb

Ms. Wolfe founded the company in 1988 She is the current CEO

1989: Performance under market returns 1990: Good performance despite down market

$25 million in assets from high-net-worth clients due to investment success

Location

Founder and CEO

Past performance

Assets

Beta Management company

Strategy

Money market instruments

Beta Management uses the market timing principle to maximize returns while reducing risks for clients via indexing. Market exposure is adjusted between 50% and 99% of equity. Most of the money is invested in noload, low expense index funds. Current exposure level is 79.2%. The rest is invested in money market instruments.

Beta Management company

Outlook

Size of assets doubled

Reaction of potential clients

Anticipation for 1991 to be a good year

Increase the proportion of assets in equities by adding stocks

Thanks to the good performance of the past years, Beta Management has doubled the size of the assets

Beta has lost potential clients wondering about why Beta was only using index funds

Ms. Wolfe anticipates 1991 to be a good year for stocks and that the market was still a good value

She decided to increase the proportion of Betas assets in equities by purchasing one of the two stocks: California REIT or Brown Group, Inc.

Beta Management company

Strategy

Where is she adding value before the change in strategy?

Maximize return while keeping risks under control

Main focus on affordable Vanguard index delivering similar return as S&P 500 Index Time the market Why do you think she is following her existing strategy? Because of a lack of time and the small volume of assets under management, she decides to follow the index strategy

Beta Management company

Strategy Change

Pressure from the potential clients

Prospection of institutional clients

Need for Growth in managed Equity

Change in Strategy

1. Calculate the variability of the stock returns of California REIT and Brown group during the past 2 years. How variable are they compared with Vanguard Index 500 Trust?

Year 1989

Month January February March April May June July August September October November December January February March April May June July August September October November December

1990

Vanguard Index 500 Trust 7,32% -2,47% 2,26% 5,18% 4,04% -0,59% 9,01% 1,86% -0,40% -2,34% 2,04% 2,38% -6,72% 1,27% 2,61% -2,50% 9,69% -0,69% -0,32% -9,03% -4,89% -0,41% 6,44% 2,72%

California REIT -28,26% -3,03% 8,75% -1,47% -1,49% -9,09% 10,67% -9,38% 10,34% -14,38% -14,81% -4,35% -5,45% 5,00% 9,52% -0,87% 0,00% 4,55% 3,48% 0,00% -13,04% 0,00% 1,50% -2,56%

Brown Group 9,16% 0,73% -0,29% 2,21% -1,08% -0,65% 2,22% 0,00% 1,88% -7,55% -12,84% -1,70% -15,21% 7,61% 1,11% -0,51% 12,71% 3,32% 3,17% -14,72% -1,91% -12,50% 17,26% -8,53%

Using the investment return Data (Table 1) we calculate the standard deviation of the index and of the two stocks.
1989 mean standard deviation mean standard deviation mean standard deviation

1990
Total

Vanguard Index 500 Trust 2,36% 3,59% -0,15% 5,30%

1,10% 4,61%

California REIT -4,71% 11,52% 0,18% 5,70%

-2,27% 9,23%

Brown Group -0,66% 5,39% -0,68% 10,51%

-0,67% 8,17%

The variability is calculated using the standard deviation. In both years and in total both stocks are more variable than the Vanguard index.

1. Which stock appears to be riskiest?

1989 1990

Vanguard Index 500 Trust mean 2,36% standard deviation mean standard deviation 3,59% -0,15% 5,30%

California REIT -4,71% 11,52% 0,18% 5,70%

Brown Group -0,66% 5,39% -0,68% 10,51%

Total

mean standard deviation

1,10% 4,61%

-2,27% 9,23%

-0,67% 8,17%

Conclusion: The stock with the highest standard deviation (variability) over 1989 and 1990 is the riskiest. In this case California REIT is the riskiest stock. Interesting is that in 1990 Brown Group was more risky than California REIT.

2. Suppose Betas position had been 99% of equity funds invested in the index fund, and 1% in the individual stock. Calculate the variability of this portfolio using each stock.

To find the risk of a portfolio, one must know the degree to which the stocks returns move together. This degree is the covariance. The covariance is calculated as the expected product of the deviations of two returns from their means The covariance between Returns Ri and Rj

Cov(Ri ,R j ) E[(Ri E[ Ri ]) (R j E[ R j ])]

Estimate of the Covariance from Historical Data

1 Cov(Ri ,R j ) t (Ri,t Ri ) (R j ,t R j ) T 1

If the covariance is positive, the two returns tend to move together.

If the covariance is negative, the two returns tend to move in opposite directions.

2. Suppose Betas position had been 99% of equity funds invested in the index fund, and 1% in the individual stock. Calculate the variability of this portfolio using each stock.

There are the results of the covariance for the three investments
Covariance between and Vanguard Index 500 Trust California REIT Brown Group 2,996 23,656 11,839 Vanguard Index 500 Trust California REIT 2,996 Brown Group 23,656 11,839

Then, we calculate the variability of the portfolio combinations

99 % of Vanguard with 1% of Variance Standard deviation Vanguard Index 500 Trust 21,218 4,606 California REIT 20,864 4,568 Brown Group 21,271 4,612

Now the portfolio with 1% of Brown Group is the riskest although Brown was the less risky stock taken alone. The riskiest stock alone California REIT decreases the risk of the portfolio. Why is that?...

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2. How does each stock affect the variability of the equity investment, and which stock is riskiest? Explain how this makes sense in view of your answer to the first question

The formula to calculate the variance of a two security portfolio is:

2 Var (RP ) x12Var (R1 ) x2Var (R2 ) 2 x1x2Cov(R1,R2 )

The riskiest stock makes in this case the portfolio less risky and the less risky stock makes the portfolio more risky. The amount of risk that is eliminated in a portfolio depends on the degree with which stocks face common risks and their prices move together. The less correlated the index and the stock are, the lower the risk (hedging). Because the covariance between Vanguard and California REIT (2.996) is much lower than the covariance between Vanguard and Brown Group (23.656), the fact that California REIT alone is riskier than Brown Group becomes secondary in the formula.

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3. Perform a regression of each stocks monthly returns on the Index returns to compute the beta of each stock.

Brown Group
20 10 0 -10 -5 -10 -20 0

y = 1.1633x - 1.9538 R = 0.4306

The sensitivity to systematic risk (Beta, the slope) is the expected percent change in the excess return of a security for a 1% change in the excess return of the market portfolio

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An investment in Brown ( =1.16) should

= 1.16

add risk to a = 1 portfolio

Return on the Vanguard Index

California REIT
20 10 0 -10 -5 -10 -20 0

y = 0.1474x - 2.4279 R = 0.0054

= 0.14
5 10

An investment in C-REIT( =0.14) should decrease risk in a = 1 portfolio

Return on the Vanguard Index

-30

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3. How does this relate to the situation described in the above question?

If we assume she has invested 99% in the Vanguard Index 500 and now decides to add another stock, then the standard deviation changes:

Std Dev now: 0.99 * 4.606 = 4.560 (1% invested in riskfree asset, Std = 0)
Invest 1 % in California REIT Portfolio Std 4.568 Original Std 4.560 Change + 0.008

Brown Group
Vanguard Index 500

4.614
4.606

4.560
4.560

+ 0.054
+ 0.046

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4. How might the expected return for each stock relate to its riskiness?

She would (probably) like the investment that is expected to provide the most excess return per unit of risk added by the investment. Such a risk return relation should equilibrate across investments. If this would not be the case, we would not invest as we have no compensation for risk. Since market risk cannot be diversified and Brown Group has the higher beta (higher sensitivity to systematic risk), they should offer a factor 1.02 (1.16 0.14) higher risk premium than California REIT. Investors can expect a superior return rate coming from Brown group, when taking the Vanguard Index as the market portfolio.

R R
C

0.008

RF

0.046

RC RF

0.008 RM RF 0.046

=0.17, which is almost exactly the Beta for C REIT

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4. How might the expected return for each stock relate to its riskiness?

The range 100% until 82 % of Vanguard is an efficient portfolio. Adding more than 18% of C-REIT in increases the volatility while decreasing the expected return.

It makes no sense to add Brown to Vanguard. The more you add Brown into the portfolio, the more the investor is worse off: the return decreases and the volatility increases

Van, CREIT
1,200 0,700 0,200 0,800 1,300

Van, Brown

4,000 -0,300
-0,800 -1,300 -1,800 -2,300

5,000

6,000

7,000

8,000

9,000
0,300

4,000 -0,200

5,000

6,000

7,000

8,000

-0,700

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