High beta is smart beta stupid!

I spent most years in the last decade trying to find, with some success, ways to make my wealth and my clients’ wealth beta neutral! But now I’m questioning …. Is a beta that’s near zero such a good thing after all? Well, it does have its merits! It would be largely recession proof, for starters! Ain’t that brilliant? Guess what? It’s not! At least, not by itself. It becomes brilliant if only a beta of zero is accompanied by a non-zero, non-negative alpha! That my friend is a non-trivial and a somewhat tall ask! For instance, a market neutral (and for simplicity’s sake dollar neutral) portfolio with half the capital randomly on the long side and the other half randomly on short side has an almost guaranteed beta of zero. But is it guaranteed to produce positive (if not market beating) returns in whatever timeframe? That might be achieved by not simply by being market neutral / dollar neutral alone. That’s what takes the non-trivial alpha in terms of asset selection, timing etc.

So, now we know a beta of zero can actually be dumb, in the absence of other ingredients to make it intelligent. Does that mean high beta is necessarily smart? Well, the good news is, high beta is indeed smart even without ingredients to generate alpha! ?

Let me illustrate with a hypothetical asset 1st and then turn it into a living example. Before that, we will try and understand this beast called smart beta. Let’s keep nuances and finer quant concepts for later. For instance, the difference between market neutral and dollar neutral might be unnecessarily quant to explain what we are trying to, in English.

OK. So, what is smart beta? It’s an animal that a ton of hedge fund managers and other quants would like to capture. Smart beta to quant traders is a bit like beavers to fur traders! And, here’s the nature of this real / mythical beast. Let’s assume all assets are benchmarked against the S&P500. Smart beta assets are things that appreciate with S&P500 with a higher beta than they depreciate! Example: Can you expect 1 share of a company can be statistically expected to rise 2% when S&P500 appreciates 1% (with no news materially impacting the company) but all only 1.5% (statistically) when S&P falls 1%? If yes, the stock of company X can be called a smart beta asset.

Does this animal species really exist? Or has it been poached to extinction? IMHO, if you are willing to go far enough on the beta axis, there is a wild west out there with hordes of these beasts, available to capture, farm, pet . . . do as you please.

Is there an example. Let’s take Ethereum or bitcoin or the entire crypto asset class. When the fed started tightening monetary policy in 2022, BTC lost about 80% of its market value in dollar terms. From that bottom it made about 600% or 7x till date. This shows a simple asymmetry. The best case profits can be a multiple of your capital but the worst case loss can never be bigger than 1x!?

But wait a minute. What if the probability of worst case loss and best case profit make the expected value of the game near zero? Guess what? These probabilities are nearly the same ?regardless of asset or asset class and that’s largely function of macros, especially money supply. If the probability (not the amount) of the worst case loss in dow jones is 5%, it won’t be very different in BTC or crypto index either, the amount of mass loss as a percentage of capital can differ. But we have clearly seen the advantage of super high beta assets there.

So, what’s the trick here? The trick is simply to buy super high beta on dips. Can they dip even more though? Why not? The trick is not to mind!

Here’s a more organized approach to buying and hodling high beta assets.

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1)????? Measure the beta of the asset you are interested in, wrt S&P500 or any such benchmark

2)????? Adjust the beta for debt (if applicable); This can influence the probability of worst case loss or even liquidation.

3)????? Measure the sharpe of the asset based on daily returns ?and eliminate those assets with a sharpe of less than 0 and those that haven’t seen life in a macro bear market.

4)????? Buy the top 5 or 10 or 20 of these on meaningful dips (say buy every dip of 20%) or systematically (like every month).

Happy investing.