Properly evaluating performance in investing is critical. For new entrants, waiting for enough time to pass to start any meaningful discussion of performance is one of the most frustrating parts of introducing a new investing strategy. Former mayor of New York City the late Ed Koch used to ask anyone and everyone on the street to review his performance with his trademark “How’m I doin’?” Now with over a year under our belt since introducing our first index strategy, we can begin to compare ourselves to others. But unlike Mayor Koch, there is no campaign trail for us to ask everyone how we’re doing–so we’ll just have to tell you.

We launched the Salt High truBeta™ US Market Index on February 7, 2018. Powered by our risk forecasting methodology, the index is designed to target higher sensitivity to market variation, which is known as beta. Since inception of the index last February, we have certainly seen our share of big market moves—both up and down—making it an excellent live-fire test of the strategy.

Since inception through June 28, 2019, the Salt High truBeta™ US Market index has returned 9.83% compared to 3.15% for the S&P 500 High Beta Index (a similar strategy), producing an excess return of 668 bps to this appropriate benchmark.[1] The index did lag the S&P 500 over the same period (total return of 12.84%), owing to a sharp burst of volatility in Q4 of 2018. But it has shown resilience in bouncing back as the market rallied in 2019, notching a 35.23% return from the December 24th lows through the end of Q2 2019.[2]

Source: Bloomberg. Past performance is not a guarantee of future results. Performance in the chart reflects total return for each index (dividends and income reinvested). You cannot invest directly in an index.

A high beta strategy is not for everyone. The cost of reaching for additional returns with this strategy is the ability to stomach higher volatility. Over the same period, annualized volatility for Salt High truBeta™ was 22.9% compared to 21.9% for S&P 500 High Beta and 15.6% for the S&P 500. Generally, investors want to maximize return per unit of risk, but a higher beta strategy will often produce a lower risk-adjusted return. However, this assumes the only strategy is to buy and hold.

A more effective way to use high beta is tactically, using it to boost exposure in anticipation of further gains or taking advantage of excess volatility to participate in a sharp rebound. A number of portfolio managers use exposure to the S&P 500 High Beta Index in their models for this very purpose. However, we believe our index has several advantages with the potential to drive outperformance.

Why (We Believe) It Works

The two indices share some aspects in common. They both target higher beta US stocks, rebalance quarterly, and consist of 100 components. But then the similarities cease. We identified five main drivers that potentially explain the differences in performance between the two approaches.

1. Selection Universe – Instead of limiting to only the S&P 500, we expand the universe to the top 1000 US stocks by market cap. However, we then filter the list by the top 500 most liquid stocks from the top 1000, which produces a unique and differentiated canvas to start from. This modified universe typically consists of 20-30% of stocks that are not in the S&P 500, but individually are more liquid than the bottom part of that list. For a technical, price-driven strategy like high beta that by design will have significant tracking error, why limit yourself to the S&P 500 to start from? This liquidity-optimized universe provides a wider selection of stocks to draw from while keeping implementation and tracking costs in mind.
2. Beta Estimate – S&P Dow Jones (SPDJI) estimates beta from daily returns over the last 252 days. This measure is better than the more common five years of monthly returns used to estimate beta but can be significantly improved for more tactical use. At Salt, we developed a proprietary process called truBeta™ that uses multiple periods of past returns and higher frequency return data to forecast beta. The result is a measure that tends to be more responsive to recent market moves and produces what we believe to be a superior estimate of market beta over the next quarter. In a white paper detailing our process and analyzing results, we find truBeta to be about 30% more accurate than the estimate used by SPDJI.[3] This is critical for identifying the stocks that are more likely to exhibit the target beta characteristics at each rebalance period.
3. Correlation Filter – There are multiple ways to mathematically calculate beta from two series of returns. One of the most intuitive involves multiplying the relative volatility of the stock to the market (ratio of the annualized standard deviations) by the correlation of the stock to the market. Framing it this way clearly defines the two levers that drive the metric. A very volatile stock with 45% volatility compared to 15% for the market and lower correlation of 50% will result in a beta of 1.50 ([45%/15%]* 0.50). Another stock with 20% volatility and a correlation of 1.0 will have a beta of 1.33. Which stock is better for creating high beta exposure? We find a simple filtering out of low correlation stocks is effective in targeting high beta more consistently and sustainably.
4. Equal Weighting –While the “beta weighting” (highest beta gets the highest weight) used by SPDJI seems to make sense intuitively, there is no quantitative evidence we can find suggesting this is an optimal method of targeting high beta. In fact, our research finds that the absolute highest beta stocks also tend to exhibit the lowest stability in their betas over time. We find a simple equal weighting scheme produces a more consistent and diversified high beta portfolio by avoiding over-weighting some of the least predictable and most volatile stocks in the selection universe.
5. Sector Constraints – Some sectors are naturally higher beta than others. Technology and energy will on average be more volatile than consumer staples and utilities. But to create a more diversified portfolio, we implement a sector constraint to limit over-concentration in any one sector—no more than 30 of the 100 stocks. For one, there are dedicated sector funds designed to provide that type of concentrated exposure. But more importantly, capping the sector exposure helps reduce risk when markets inevitably become over-exuberant. This may detract from performance at times by limiting the contribution from a top-performing sector. But we find the risk-reducing benefits far outweigh the negatives based on the historical evidence—and the likelihood the next crisis will be concentrated in some segment of the market that generates a little too much enthusiasm.

A little over a year is still a relatively short period to evaluate any investing strategy, but we are still proud of the way the index is performing. While we are pleased it is outperforming the S&P 500 High Beta benchmark, no strategy is perfect and will likely experience bouts of underperformance from time to time. Instead, we judge ourselves on the ability for the strategy to meet its targeted objective and give the investor the desired exposure. Based on the experience of the past year with a couple of big swings in the market in both directions to test it, we would say it does.

For a portfolio manager with either a higher beta mandate or a model that can tactically take advantage of its capabilities, the Salt High truBeta™ US Market index is a potentially more potent alternative to the S&P 500 High Beta Index. If your goal is to build a model that can outperform, you should use the best tools available in the market—before your competitors beat you to it.

[1] Bloomberg, 6/28/2019

[2] Bloomberg, 6/28/2019

[3] For additional information on truBeta™, see the Salt Financial white paper “Quarterly Beta Forecasting with Multiple Return Frequencies”, available at https://tinyurl.com/y89xjjxk

The information provided herein is for information purposes only and is not intended to be and does not constitute financial, investment, tax or legal advice. All investments are subject to risks, including the risk of loss of principal. Past performance is not an indicator of future results.

The information and opinions contained in Salt’s blog posts, market commentaries and other writings are of a general nature and are provided solely for the use of Salt. This content is not to be reproduced, copied or made available to others without the expressed written consent of Salt. These materials reflect the opinion of Salt on the date of production and are subject to change at any time without notice. Due to various factors, including changing market conditions or tax laws, the content may no longer be reflective of current opinions or positions.

The information contained herein is not intended as a recommendation to buy, hold or sell any security. The investment performance described herein is simulated and does not reflect actual performance data. Actual investment performance may vary. There is no guarantee that an investment will be profitable and all investments bear the risk of partial or complete loss of capital. Past performance is not an indicator of future results.

Any market observations and data provided are for informational purposes only. Where data is presented that is prepared by third parties, such information will be cited, and these sources have been deemed to be reliable. However, Salt does not warrant the accuracy of this information. Salt and any third parties listed, cited or otherwise identified herein are separate and unaffiliated and are not responsible for each other’s policies, products or services.

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