A zero-beta portfolio is a portfolio constructed to have zero systematic risk, meaning it achieves a beta of zero. Essentially, a zero-beta portfolio is designed for a return match with the risk-free rate rather than directly correlating with market fluctuations. As the expected return aligns with the risk-free rate, such a portfolio would not exhibit any correlation with broader market movements, and typically, this results in a lower rate of return compared to portfolios with higher betas.
During bull markets, zero-beta portfolios may fail to garner widespread investor interest. Due to their lack of market exposure, they tend to underperform when compared to broadly diversified market portfolios. Despite this, in bear markets, zero-beta portfolios may pique some interest. However, cautious investors might prefer risk-free, short-term treasury investments which accomplish similar goals potentially at a lesser expense. Complete elimination of risk through a zero-investment portfolio remains theoretically unfeasible.
Key Insights
- A zero-beta portfolio is designed with zero systematic risk, achieving a beta of zero.
- Beta represents an investment’s sensitivity in relation to movements of a specific market index.
- Zero-beta portfolios lack market exposure, and as a result, are less appealing to investors during bull markets due to underperformance when compared to diversified market portfolios.
Understanding Zero-Beta Portfolios
Beta and Formula
Beta measures a stock’s (or other security’s) sensitivity to price movements of a referenced market index. It gauges whether an investment is more or less volatile compared to the benchmark market index.
A beta above one indicates higher volatility than the market, while a beta below one signifies lower volatility. Negative beta values can occur, reflecting an inverse relationship with the market.
Consider a large-cap stock: it might have a beta of 0.97 relative to the Standard and Poor’s (S&P) 500 index and a beta of 0.7 compared to the Russell 2000 index. Conversely, it could exhibit a negative beta concerning an unrelated index, such as an emerging market debt index.
The formula for beta is:
Beta = Covariance of Market Return with Stock Return / Variance of Market Return
Crafting a Zero-Beta Portfolio
Here’s a straightforward example to illustrate a zero-beta portfolio. Imagine a portfolio manager with $5 million wanting to build a zero-beta portfolio against the S&P 500 index using different investments:
- Stock 1: Beta of 0.95
- Stock 2: Beta of 0.55
- Bond 1: Beta of 0.2
- Bond 2: Beta of -0.5
- Commodity 1: Beta of -0.8
By assigning capital as follows, the manager can craft a near-zero beta portfolio:
- Stock 1: $700,000 (14% of the portfolio; weighted-beta of 0.133)
- Stock 2: $1,400,000 (28%; weighted-beta of 0.154)
- Bond 1: $400,000 (8%; weighted-beta of 0.016)
- Bond 2: $1,000,000 (20%; weighted-beta of -0.1)
- Commodity 1: $1,500,000 (30%; weighted-beta of -0.24)
This configuration results in a combined beta of -0.037, classified as a near-zero beta portfolio.
Related Terms: risk-free rate, rate of return, underperform, market portfolio, zero-investment portfolio.
