What Is a Zero-Beta Portfolio?
Let me explain what a zero-beta portfolio really is. It's a portfolio I've built to have zero systematic risk, which means it has a beta of zero. This setup gives it an expected return matching the risk-free rate. You'll see that it has zero correlation with market movements, so its returns stay low compared to higher-beta options.
You won't find much investor interest in these during bull markets because they lack market exposure and underperform diversified portfolios. In a bear market, they might draw some attention, but you have to ask if short-term treasuries aren't a simpler, cheaper choice. Theoretically, eliminating all risk with a zero-investment portfolio isn't fully achievable.
Key Takeaways
Here's what you need to grasp: A zero-beta portfolio is made to have zero systematic risk, equating to a beta of zero. Remember, beta tracks how sensitive an investment is to movements in a specific market index. These portfolios avoid market exposure, so they won't attract much interest in bull markets where they'd lag behind broader market gains.
Understanding Zero-Beta Portfolios
Let's dive into beta and its formula. Beta measures a stock's or security's sensitivity to price changes in a referenced market index. It tells you if the investment is more or less volatile than that index.
Beta and Formula
If beta is over one, the investment is more volatile than the market; under one, it's less volatile. Negative betas mean it moves opposite to the market. For instance, a large-cap stock might have a beta of 0.97 against the S&P 500 but 0.7 against the Russell 2000, and even negative against an unrelated index like emerging market debt.
The formula is straightforward: Beta equals the covariance of the market return with the stock return, divided by the variance of the market return.
A Simple Zero-Beta Example
Consider this example to see how it works. Suppose you're a portfolio manager with $5 million to invest, aiming for zero beta against the S&P 500. You have options like Stock 1 with beta 0.95, Stock 2 at 0.55, Bond 1 at 0.2, Bond 2 at -0.5, and Commodity 1 at -0.8.
Allocation for Near-Zero Beta
- Stock 1: $700,000 (14% of portfolio; weighted beta 0.133)
- Stock 2: $1,400,000 (28% of portfolio; weighted beta 0.154)
- Bond 1: $400,000 (8% of portfolio; weighted beta 0.016)
- Bond 2: $1 million (20% of portfolio; weighted beta -0.1)
- Commodity 1: $1.5 million (30% of portfolio; weighted beta -0.24)
Final Thoughts on the Example
With this allocation, the portfolio ends up with a beta of about -0.037, which is close enough to zero for a near-zero beta setup.
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