October 07, 2021
In case you missed it, the stock market has been through hell and back in the last year. The COVID-19 pandemic prompted a global selloff in markets, the runoff of stimulus money to shore up economies, and left millions stranded at home bored out of their mind.
As the dust settled and the economy reopened, many smart investors had already begun buying stocks at discounts. Investors picked up companies that were sensitive to changes in consumer behavior. That included airlines, cruise lines, rental car companies, fashion brands, other consumer discretionary names. Since COVID was the “ultimate change to consumer behavior,” these companies went on sale—and that “discount searching” accelerated as millions of retail investors began to hop onto brokerage apps such as Robinhood and Public.
For many of these investors, making a decision to invest in a battered name like Southwest or Royal Caribbean was as simple as zooming out of the COVID price action and looking at the trend. What they saw were household names, which had a meaningful history of growth, down over 50%. Of course, we know what happened next: many investors who bought the dip were rewarded handsomely.
However, over a year after the COVID-19 pandemic, there are still companies suffering the COVID blues. That means that some brands are trading below their pre-COVID prices. Some investors might look at that and see discounts, but that isn’t a guarantee. But, regardless, there might be a few reasons why you might want to invest in stocks that have been tossed around. This is where smart beta comes in, and it might be a meaningful way for investors to gain exposure to battered names.
What is beta?
We’ve covered the concept of market volatility. This idea is pretty simple: you can’t expect stocks to go up in a linear fashion. You won’t accrue gains in a straight line. There will be periods when stocks go up, down, sideways, and all over the place—and, yes, we sympathize with you. It’d be great if markets were just an infinite money glitch, but they’re not. There are going to be bumps in the road, but those bumps in the road might represent an opportunity.
This is where we revisit a theme from our market volatility blog post called beta. Beta is a measure of volatility, relative to an index like the S&P 500. The index will usually have a score of 1.0, which is the base score from which we can evaluate volatility. Any stock with a beta score greater than 1.0 (higher than the index) is more volatile than the index, and (theoretically) the broader market. When a stock has a beta score lower than 1.0 (lower than the index), this implies that the stock is less volatile than the index and the market.
So, why does this matter to you? Well, though beta and volatility don’t correlate with returns, you might be able to use your knowledge of a stock’s beta (or a basket of stocks) to get ahead. Let’s examine how:
Low Beta Strategies
In a highly sensitive market, low beta strategies are likely to react less to movements in the broader market. For some investors who have mild anxiety after the wild correction in March 2020, having exposure to stocks with lower volatility might sound attractive already. However, an added benefit is that low beta stocks tend to outperform the market.
Many low volatility/low beta strategies will typically find an overlap with companies you’d consider to be “value stocks.” As a result, you’ll tend to see names which are synonymous with value such as Berkshire Hathaway, Verizon, Waste Management, and the like. These companies don’t necessarily have “sexy” business models, but they generate returns while remaining less sensitive to the market.
High Beta Strategies
One alternative to low beta strategies are high beta strategies. A high beta strategy will traditionally invest in companies that have seen high volatility compared to the broader market. One foundation of investing theory is that risk = reward. In that sense, high beta might be an investor’s way to make more money.
In a time like now, which is already volatile, high beta strategies have mostly boiled down into a list of companies that have seen tremendous upheaval as a result of COVID-19. And though there’s no guarantee that the most affected stocks will bounce back, there are fair odds they will. Some of the biggest holdings comprising high beta ETFs in 2021 are financial, energy, travel, and leisure companies such as Carnival, Discover, Ameriprise, and the like. In that sense, if you’re unafraid of some of the risk that comes with these more volatile stocks, a high beta strategy might be a means to bet on the reopening of the economy.
Fund to Check Out: S&P 500 High Beta Index ($SPHB)
Smart Beta Strategies
One last alternative to high or low beta strategies is so-called “smart beta strategies.” Smart beta ETFs generally track an index, but consider alternative factors in choosing stocks in the index. In that sense, smart beta blends active and passive management strategies.
There are quite a few different kinds of smart beta strategies out there. The most common ones include equal-weighted indexes, where each component in a fund has an equal amount of money invested in it at the start. Some might look at fundamentals or factors such as valuations, balance sheets, or growth. There are also smart beta strategies which plagiarize the high and low beta strategies, but add more guardrails to their policy for investing. In that sense, smart beta is a little more complicated—you’ll have to take a look in order to find one that fits your needs, but you’ll get something closer to what you want than an index strategy.