Investors utilize a wide range of financial metrics when performing investment analyses. It is critical to have as deep an understanding of an investment opportunity as possible before buying into that security. One of the most widely utilized metrics is known as beta, which is used in fundamental analysis, including in the capital asset pricing model (CAPM), among others.
Beta might be one of the most important financial metrics you’ve never heard of. This article will discuss beta, what it is, and what it means for your exchange-traded funds (ETFs).
What Is Beta?
First, investors should gain a better understanding of what beta is and how it affects equities and ETFs.
Beta is a statistical metric often used in investment analysis. It analyzes a stock’s sensitivity in relation to the broader market, usually measured by the S&P 500 Index. The most frequently used ETF that corresponds to the S&P 500 Index is the SPDR S&P 500 ETF (SPY ).
Beta measures how much a stock is expected to move on a daily basis, up or down, in relation to how the S&P 500 Index moves. Basically, it’s a measure of market or systematic risk of a security. For example, a stock with a beta of 1.0 moves in line with the overall market, so that a 1% rise or fall in the S&P would be matched by a 1% rise or fall in that stock’s price.
The lower the beta value, the less sensitive the underlying instrument is in comparison to the market. There are many securities with beta values of 0.50 or lower. For example, according to Google Finance, the SPDR Gold Trust (GLD ) has a beta value of 0.16; that means that if the S&P 500 increases 1%, the gold ETF is expected to rise just 0.16%. The ETF has a lower beta value because its fundamental drivers are different from those of equity ETFs.
As a result, constructing a portfolio of investments that have blended or mixed beta values can be a good risk management tool. An investor can position himself or herself with downside protection in case the equity markets drop. For example, the SPDR S&P Dividend ETF (SDY ) has less market volatility than the S&P 500, with a 0.80 beta value. That is because SDY comprises high dividend yield stocks, which are typically less volatile as a group.
Similarly, fixed-income ETFs tend to have lower beta values as bonds are typically less sensitive to market movements than stocks. The iShares Investment Grade Corporate Bond Fund (LQD ) is a bond ETF that invests in investment-grade corporate bonds. It has a beta value of just 0.07, which means it is not sensitive to market movements.
Alternatively, investors can seek out riskier ETFs with higher-than-normal levels of market related volatility. One example is the SPDR S&P Emerging Markets Small Cap ETF (EWX ), which comprises small-capitalization equities in the emerging-markets region. These are more speculative investments and as a result the ETF carries a 1.28 beta value.
The Bottom Line
Beta can be a very useful tool in financial analysis. The metric helps identify which stocks are typically stable and less volatile, or more volatile, depending on the investor’s particular level of risk tolerance. Investors who are more risk-averse and who do not want to be exposed to high levels of risk (such as retirees) should generally tilt their investment portfolios toward ETFs that have lower beta values.
On the other hand, younger investors with a longer investment time horizon may want to hold ETFs with higher beta values. Those ETFs are likely to have a stronger risk-reward profile, which could be suitable for young investors who have the benefit of time to ride out any investment losses.