With the market clearly returning to "risk-on" mode in the past two weeks, it may be time for investors to revisit the riskiest sectors of the market. Yes, I am gearing up for market prognosticators to once again shout "buy beta!" The positive vibes on trade coming from both the U.S. and Chinese governments have overshadowed an earnings season that has been lackluster at best, in my opinion. I have been more worried about the bond market than the stock market, but in today's trading the yield curve finally reverted, with the 5-year U.S. Treasury note now yielding a whopping one basis point more than the 2-Year's 2.62% yield.
Is all well? No, I am not convinced. As I am already starting to hear the drumbeat of "buy beta" from financial advisors, though, I believe it is important that the average investor understands just what beta is and what it measures.
When a financial advisor says buy beta, he or she is usually referring to buying stocks and ETFs that have relatively high covariances in performance with the S&P 500. A stock with a beta of 1.0, for example, has displayed zero covariance with the benchmark index. The standard deviation in returns over the given period would be equal.
Meanwhile a stock with a beta of 2.0 has produced double the standard deviation in performance of the S&P 500 over a given timeframe (I use 3-year betas), while a stock with a beta of 0.50 has produced half the standard deviation of performance of the S&P 500. Negative betas are possible and do exist in derivative securities like 2x- and 3x-short ETFs, but in the world of common stocks they are quite rare.
So, generally speaking, we can look at a beta and discern whether the stock has produced a greater standard deviation versus its mean return than the S&P 500 has. Higher beta means more amplitude, and in the main valuation metric favored by Wall Street -- the Capital Asset Pricing Model -- a higher beta will produce a higher required return for a given security. Please do not confuse actual volatility with implied volatility, which is a key pricing component of options and futures and contracts. For stocks, high beta means higher returns are needed to justify holding them in the face of greater amplitude versus the overall market.
So, If things really are "risk on" you should be letting it rip and positioning your portfolio in the highest-beta names. Those stocks should be expected to outperform the S&P 500 by the percentage implied in their beta coefficient, assuming past performance is a perfect indicator of future results (which of course it is not.)
Disclaimers aside, here is a list of the State Street Global Advisors select sector SPDRs and their betas vs. the S&P 500. Highly cyclical sectors and sectors that have higher valuations could be expected to have higher betas than more defensive sectors that are lower-rated and produce less variability in earnings, and the table shows that is indeed the case.
That said, I was surprised by many of the sector beta readings. With the huge pullback in megacaps such as Exxon Mobil (XOM) and Diamondback Energy (FANG) , for instance, I would have thought energy - (XLE) - would have by far the highest beta, for instance, but that is not the case. Similarly, I am not a big believer in the theory that consumer staples stocks are heavily defensive (look at a chart of Kraft Heinz (KHC) for a counter-example), but the sector's low beta shows that, over the past three years anyway, that sector - (XLP) - has displayed much less amplitude than the market.
Note that this table excludes the newest Sector SPDR, Communications Services - (XLC) - owing to its lack of performance history. All data sourced from Morningstar.com.
| Sector | SPDR | 3-yr. beta |
| Consumer Discretionary | XLY | 1.08 |
| Consumer Staples | XLP | 0.48 |
| Energy | XLE | 1.11 |
| Financials | XLF | 1.10 |
| Healthcare | XLV | 1.01 |
| Industrials | XLI | 1.15 |
| Materials | XLB | 1.12 |
| Real Estate | XLRE | 0.68 |
| Technology | XLK | 1.03 |
| Utilities | XLU | 0.17 |
