High Beta Index

It tracks stocks with a relatively higher Beta or volatility

Author: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Reviewed By: Josh Pupkin
Josh Pupkin
Josh Pupkin
Private Equity | Investment Banking

Josh has extensive experience private equity, business development, and investment banking. Josh started his career working as an investment banking analyst for Barclays before transitioning to a private equity role Neuberger Berman. Currently, Josh is an Associate in the Strategic Finance Group of Accordion Partners, a management consulting firm which advises on, executes, and implements value creation initiatives and 100 day plans for Private Equity-backed companies and their financial sponsors.

Josh graduated Magna Cum Laude from the University of Maryland, College Park with a Bachelor of Science in Finance and is currently an MBA candidate at Duke University Fuqua School of Business with a concentration in Corporate Strategy.

Last Updated:December 8, 2023

What is a High Beta Index?

Like most Wall Street lingo, Beta, too, can be made comprehensible to people with no background in finance. In the simplest terms, it is a measure of the volatility in the pricing of a financial instrument, such as stocks, bonds, and indices, to name a few.

The Beta coefficient of an instrument is measured by dividing the covariance of a stock with the market return by the variance of the market return. 

In even simpler terms, it is the movement in the price of a financial instrument and its correlation with the price movement of a benchmark index.

This is often used to determine the risk associated with a specific financial instrument. Higher the Coefficient, the higher the risk associated with the asset or instrument. 

The reason to assume higher risk is the volatility of the specific asset, as unfavorable market conditions tend to disproportionately affect their price movement. 

β = Covariance of Market Return with Stock Return/ Variance of Market Return

Key Takeaways

  • Beta is an indicator of volatility and risk.

  • High Beta Indices are suitable for aggressive investors or traders with a higher risk-taking appetite with funds over their needed annual savings.

  • High Beta Indices can be used during economic downturns or bear markets to generate extraordinary results by betting on an upcoming bull run or a market correction.

  • Higher volatility does not always result in higher returns or risk in the long run.

  • A high Beta index has underperformed the standard Index in the long run but provides an opportunity for high short-term gains during specific periods.

What is an Index?

An index is simply a cumulation of different financial assets used to trade a bunch of assets in one go rather than individually. 

The most common use of this is on the stock market, where stocks of companies are picked on standard criteria and turned into an Index. In common lingo, the most extensive index of any country is referred to as "The Market."

Examples of Indices

  • S&P 500- The Standard and Poor's Index tracks the 500 largest companies primarily based on the market capitalization of all the publicly listed companies in the USA. This massive index represents approximately 80% of the market capitalization of all the listed companies in the USA.

  • DJIA- The Dow Jones Industrial Average Index tracks 30 of the USA's largest and most influential companies. These companies are relatively stable and consistent with their dividends.

  • NASDAQ Composite- The NASDAQ Composite Index tracks the most extensive stocks listed on the NYSE and NASDAQ, an exchange exclusively for the technology sector and ten other subsectors such as semiconductors, utilities, and energy.

Understanding High Beta Index

As the name would suggest, it tracks stocks with a relatively higher Beta or volatility. Investors or traders usually prefer High Beta Indices with a higher risk appetite. 

For that reason, it is preferred by individuals or institutions willing to accept a higher risk for a higher rate of return. 

Note

Beta is only a statistical property based on historical data and only indicates future price movement.

Different Beta

The Beta coefficient of an Index compares its volatility to the broader market using the variance and covariance of the assets. There are five basic scenarios based on Beta.

  • Beta > 1 - In this scenario, since the Beta of the asset is more than 1, the price movement would be relatively more volatile than the benchmark index. Example - If asset H has a Beta coefficient of 1.5, it would indicate that historically, for every 1% change in the benchmark index, asset H sees a change of 1.5% in the same direction. 
  • Beta = 1 - In this scenario, since the Beta is equal to one, we can infer that the price movement of the asset in question is the same as the benchmark index. Example - If an asset S has a Beta coefficient of 1, for every 1% change in the benchmark index, the asset will face a value change of 1% in the same direction.
  • Beta < 1 - In this scenario, since the Beta is lesser than 1, the price movement would be relatively less volatile than the benchmark index. Example - If an asset L has a Beta of 0.5, we can infer that for every 1% change in the market value of the benchmark index, the asset in question would move by 0.5% in the same direction. 
  • Beta = 0 - A Beta value of 0 indicates no correlation between the asset's price movements and the benchmark index. Cash and gold are considered to be assets with 0 Beta coefficient (Discounting inflation)
  • Beta < 0 - A negative Beta value indicates an inverse relationship between the asset's price movements and the market.

Usually, no significant assets have a negative Beta coefficient. However, theoretically, if the Beta coefficient of an asset is negative 1, it would imply that for every 1% change in the benchmark index, the asset value changes by 1% in the opposite direction.

A high Beta index is an index that has a higher Beta coefficient than its benchmark/ peer Index. Usually, it is created using the most volatile stocks (Stocks with the highest Beta coefficient) from a given Index. 

The “S&P 500 High Beta Index” is the most famous High Beta Index, created by basketing the 100 most volatile stocks in the S&P 500 Index. 

The five-year monthly Beta coefficient of this Index is 1.49, which means that, on average, the Index moves 49% times faster in the same direction as the S&P 500.

Returns from a High Beta Index

First created in 2011, the S&P 500 High Beta Index was created to allow traders or Investors to make directional trades and investing decisions on the market.

Over its 11-year span, the S&P 500 High Beta Index has provided approximately a CAGR of 8.82%, while its benchmark (S&P 500) provided a CAGR of 15.18%.

This does make the SP500HBETA seem like an unwise investment since it offered lower returns than its benchmark despite the higher risk. 

However, if we look at a time frame of one year (Jan 2020- Jan 2021), the SP500HBETA provided an unbelievable return of 39.76% compared to a return of 25.83% given by the SP500. 

This sort of data tends to put investors and traders into a dilemma, whether a High Beta Index is the fastest way to build wealth or whether they should go safe with the standard Index.

To solve this dilemma, we need to understand that a higher CAGR return over a specific time period does not necessarily mean it is a better investment for every individual. There are some significant differences between the time period of investment and investors' return expectations for both indices, which is the key to deciding your ideal investment.

Why Investors Like High Beta Index Stocks

The primary investors in the High Beta Indices are traders / Investors who have a directional view (Bullish or bearish) on the market; this view could be based on the technical or fundamental analysis performed by the individual. 

Advantages of a High Beta Index are:

  • More significant price movements allow for bigger gains

  • The positive price movement allows investors to beat inflation by a margin

Disadvantages of a High Beta Index are:

  • Higher volatility indicates higher risk.

  • A bearish movement would force the investor/ trader to either exit positions as a heavy loss or hold them and wait for a bullish movement.

When and what to Invest?

Every sane investor tries to answer a question before entering a position “When to enter, and how much to invest.” It is important to understand the key features of High Beta Indices to answer the question.

When to invest?

  • When you hold a decisive view on the movement of the markets (Bearish or Bullish) for any timeframe according to your comfort level.

  • Technical- If the markets are oversold or overbought or give any strong technical indication using price action or indicators such as RSI, MACD, Supertrend, etc., towards any direction. This method is usually preferred by traders who usually stay in a position for a short period of time.

  • Fundamental- If the investor analyzes the fundamental aspects of the market either quantitative (Using ratios and multiples such as P/E) or qualitative (understanding the core businesses and industries on a management level) and holds a solid long-term view of the market movements. 

What to Invest?

Every portfolio ideally should be divided into separate asset classes and different risk-level assets. Conventionally low-risk assets are usually the major component of an investment portfolio, and high-risk, high-return assets are a minor component.

Following the same pattern, an investor would be advised to only invest a small amount of capital in a High Beta Index, which they will not require in the short term.

Traders conventionally follow the rule of 1% while making trading decisions and would follow the same on this asset as well.

Alternatives to High Beta Indices

For investors/ traders who only wish to invest in a High Beta index for the volatility and not the stocks it is composed of, leveraged Indices could be an alternative that provides higher volatility due to leverage.

Researched and authored by Yatharth Gupta | LinkedIn

Reviewed and Edited by Krupa Jatania | LinkedIn

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