Movable Beta

The Fed has cut rates by ¾ of a point to 4.5%, though the market wants more. Short-term T-Bill rates have fallen from 5% to 3%. Today’s lower rates will be a big factor in getting this economy moving again, but not until later next year. There is a lag to monetary policy.

For now, though, the Fed’s easy money policies won’t save Countrywide from itself. Big banks that used to funnel money to thousands of tiny mortgage lending companies have closed their loan warehouses down. They say that it’s to get a handle on loan quality, as if their own internal lenders were somehow exempt from the same sloppy lending practices that caused the housing bubble in the first place. In reality, the banks need every dollar they can get to prop up their own institutions.

Freddie Mac, the no longer government-backed company that became addicted to borrowing at rates just barely above treasury levels, is paying 8.375% to borrow $6 billion so it can continue purchasing mortgages that yield around 6.25%. Citigroup went hat in hand to the Middle East to borrow petrodollars from Abu Dhabi at 11%, though the prime rate for U.S. borrowers is 7.5%. Adding to the mix E-Trade sold its toxic collection of mortgages to a hedge fund for 27 cents on the dollar. With such stellar capital allocations moves as these, it’s unlikely that we have yet turned the corner on earnings disappointments in the financial sector.
 
The market lost momentum in the financial and consumer cyclical sector a long time ago, but the lack of enthusiasm for equities has extended to most mid-caps and small-caps, telephone stocks, and even healthcare. Stalwarts like international, energy, technology, and materials had a tough month. Our fund portfolios purchased some long bonds this month. This effectively reduces what has been an above-market portfolio beta to roughly a market beta. There’s nothing wrong with boosting beta when markets are doing well. In some markets, however, it pays to be a risk manager.
 
Volatility (the kind where the market goes down) has for the third time this year again introduced itself to investors. Upside volatility is actually a good thing, but Wall Street typically uses the word volatility to avoid acknowledging the fact that sometimes markets go down. In their view, sometimes markets go up – and sometimes they are volatile. Beta is a term linking portfolio volatility to that of the overall market. A beta of 1.1 is 10% more volatile than the market. If the market rises 10%, a portfolio with a beta of 1.1 will rise 11%. If volatility inexplicably leads to a market decline to 10%, the higher beta portfolio will decline by 11%.
 
Since markets generally go up, some investors live mostly in a high beta world, hoping to outperform the market by taking greater risk (structuring a high beta portfolio). They can emphasize small cap stocks over larger names. They can focus on volatile sectors like technology or commodities. They might prefer companies with high debt ratios, or even use margin to leverage their own portfolios.In general, these always-aggressive portfolios are sort of a ticking time bomb. They work well, most of the time, but when the market goes against them they can lose most if not all that they gained on the way up. A lot of hedgers build these portfolios and given the pay structure of the hedge fund industry (tails I win, heads you lose), it makes sense (for the manager).
 
ETF Scout believes that portfolio beta ought to adjust to reflect current economic and market conditions. In a perfect world, investors want a high beta portfolio when the market is moving up, and a zero beta portfolio when the market is falling. While ETF Scout is not perfect, we see that the ability to adjust the beta, or risk, as one of the pillars of our investment strategy. From our standpoint if an investor is paying for active management they should demand a variable beta portfolio.Isn’t that what you are paying your managers to do? It makes sense to risk more when the markets are doing well, but risk less in times of trouble.
 
The epitome of this is the Will Rogers trading strategy. He said, “Trading is easy. Only buy stocks that are going up. If they don’t go up, then don’t buy them.” Easier said than done. But the idea that portfolio beta ought to move around, which is a more realistic version of the Will Rogers trading strategy, is considered heresy to Wall Street’s “buy and hold” convention.In recent years, the ETF Scout portfolio has done well partly because our portfolio has had an above average portfolio Beta during what has generally been a very kind five year period for investors.
 
In December, we once again re-introduced bonds to the portfolio. The effect will be to reduce overall portfolio beta. We are now less sensitive, at least for the time being, to what Wall Street calls “volatility.” If the market weakens further, we will reduce it even more. Happy Holidays.

 

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