Today we’re going to discuss a key trend in the Beta factor that has heavily impacted investor portfolios during the turbulence of the past few weeks. This is the dominant factor to keep an eye on as we’re seeing significant polarization in company exposure to Beta, resulting in a phenomenon that has hurt investors as the market both falls and rises. We’ll elaborate further on “Runaway Beta,” including some data that can help provide historical context, and discuss ways to immunize your portfolio against it. We’ll also provide our weekly market and factor update.
But first, our thoughts go out to all those being impacted by the COVID-19 pandemic and we hope for the continued well-being of you and your loved ones. We’d like you to know that we have a full suite of contingency and preparedness procedures in place to ensure that the platform will continue to serve your needs without any service interruptions. Omega Point and our data partners Qontigo, MSCI, Wolfe Research, & OWL Analytics are here to support you and help your firm navigate these rough waters.

Beta Has Gone Parabolic

In all of today’s observations, we’ll use the Axioma US Short Horizon model, which is better suited to capture short-term trends. In this model, Market Sensitivity (Beta) is defined as the 6 month daily performance regression of a stock vs. the market.

This is how Beta has performed since Feb 11, when WHO named the coronavirus COVID-19 and it became clear that it was on the cusp of becoming a true pandemic:

As a reminder, the factor return is based on a portfolio that is long high Beta stocks and short low Beta stocks — so this chart tells us that higher Beta stocks are vastly underperforming lower Beta stocks. The reasons for this are several, including the fact that high beta names usually have more risk associated with them, and thus get punished in a risk-off environment. Higher beta names also typically have more growth expectations baked into their price, so when global growth is likely to swing negative, the short term expectations for these names get crushed.

Beta Today vs. the Global Financial Crisis

Factor return for Beta is down almost 7% over last month alone, but there may be much further it can go if its behavior during the financial crisis is any indication. Below shows the Axioma Market Sensitivity cumulative factor return during the current market environment, compared to the market leading up to the Financial crisis when Lehman failed, and the resulting behavior after the market drop.

Here we see the depths to which Beta factor returns plumbed during the GFC, which is the closest comp to our current market decline. Something we’d note is that because Beta return has fallen at a sharper rate than it did during the GFC so far, it’s possible that it may also recover at a quicker rate from trough than it did back then, as well. This recovery may also be amplified by the broader global usage of the internet and social media in the event that good news about the virus (a vaccine, effective treatment, etc) of the virus is announced.

Beta Is Becoming More Polarized

It’s clear that the betas of securities in the market are changing quickly under these conditions. When we say polarized, what we mean is that market sensitivities are running away in both directions. As names that have higher exposure to Beta are consistently becoming even higher Beta, names with lower exposure to Beta are seeing that exposure move lower.

Our below analysis shows how the distribution of Predicted Beta of Russell 3000 assets has shifted towards higher betas:

When a crisis hits and certain industries and countries are hit harder than others, Runaway Beta can quickly hit any asset. For example, funds that hold retail and travel names will see Beta creep (more like a sprint) to unprecedented levels. To illustrate this point, let’s take a look at a couple of of stocks that have exhibited this dynamic from both ends of the spectrum.

Here’s Avis Budget (CAR), a stock that’s suffered as travel-focused companies have borne the brunt of market losses. Share price is down -58.4% since Feb 11 and has underperformed the Russell 3000 by 32% during that time (see chart below).

This is CAR’s Beta exposure during that same time. It’s evident that as the stock price dropped faster than the market, Beta exposure popped from +1.18 on Feb 11 to +3.15 on Mar 12, after hitting a peak of +3.45 on Mar 6th.

Every single day, names like this are taking on additional Beta exposure, which continues to build as the market falls, effectively creating an Ouroboros of Beta.

This same dynamic can also lead to runaway negative beta. For instance, Gilead Sciences (GILD) has a drug (Remdesivir) being tested as a potential treatment for COVID-19. This stock has vastly outperformed the broader market (+27% against the Russell 3000 since 2/11).

From a Beta perspective, GILD had already started the period underweight the factor with an exposure of -0.35 exposure. Today, it sits at a much lower -2.01.

What we’ve attempted to show here is the extremity of the dispersion of predicted Beta and Beta exposure in today’s market environment. This polarization of Beta can lead to more unintended risks and massive swings in your portfolio, regardless of your portfolio positioning. In the hedge fund world, we’ve seen this play out this month as a lot of firms have experienced the double whammy of losing money as the market moves in either direction. Using the GFC as an analog, it’s clear that we neither want to be long Beta on the way down, or short on the way back up.

If COVID-19 ends up disrupting the economy as much or more than the Financial crisis, there could be much more volatility in the markets and runaway Beta issues to deal with in portfolios. Even if you’re only slightly exposed to Beta, you’re going to be subject to the volatility, and even if you hold negative Beta exposure, you can get hurt on the rebound.
Even an equity market neutral fund that’s grossing down positions might still have a mismatch in the portfolio as it’s more invested in higher Beta names that are increasing that Beta exposure by the day.

So, what can be done to protect our portfolios from runaway Beta?

Potential Solutions

Since it’s clear that we don’t want to be caught on either end of this dynamic: if you can avoid beta, then it’s prudent to do so as much as possible until market volatility has dried up.

To this end, these are some of the ways that Omega Point has been able to help our customers:

1. Active rebalancing - Making small adjustments to your portfolio daily to trim runaway beta securities, allowing you to stay ahead of these big moves.
2. Dynamic hedging - Often, trimming your core holdings is not an option. Overlaying your portfolio with daily rebalanced hedge baskets can guard your book against the beta fallout. The hedge baskets can be built from your coverage universe or interest list of names you are comfortable with.

While we hope this disruption to the global markets, economy, and way of life is as short-lived as possible, it’s safe to assume that volatility will continue to envelop our screens for the foreseeable future. We are here to help, so please feel free to reach out to me at any time to discuss any of the above, and use us as a resource early and often.

US Market: 3/06/20 - 3/12/20

• On Thursday, all three major indices fell by nearly 10%, in the worst session since 1987’s Black Monday. This was in response to what the market considered to be the Trump administration’s feeble and misguided response to the virus.
• On Friday (not captured in above chart), Trump declared a national emergency, opening up access to $50B for states affected by the outbreak. In response, stocks surged into the close on Friday, nearly recouping the losses from the previous day. The S&P 500 still ended the week down 8.8%.
• OPEC+ was unable to agree on production cuts, causing crude to fall as low as $27 per barrel - its worst weekly decline since the GFC.
• 10-year Treasury yields fell below 0.4% for the first time ever, and yields on all maturities touched below 1%. At this time, the market is pricing in a 100bps rate cut in the Fed’s March meeting. Meanwhile, the Fed conducted another emergency liquidity operation.

Factor Update: Axioma US Equity Risk Model (AX-US4)

• Profitability was the biggest winner as the flight to safety continued, with a massive +1.53 standard deviation move that had the factor approaching an Extremely Overbought label.
• Size and Earnings Yield also saw normalized gains, with Size becoming an Overbought factor, and Earnings Yield escaping Oversold territory.
• Value took another leg down and now sits at -2.79 SD below the mean.
• Volatility saw a sharp downward move, falling 0.75 standard deviations in the past week as it continued to sell off.
• Market Sensitivity fell 0.86 standard deviations in the Medium-Horizon model, and sits at -2.99 SD below the mean...deep in Extremely Oversold territory.
• Growth was again the biggest loser, crossing over the mean and into negative space at -0.36 SD below the mean.
• US Total Risk (using the Russell 3000 as proxy) saw a nearly 9% gap up after a tumultuous week.

Factor Update: Axioma Worldwide Equity Risk Model (AX-WW4)

• Earnings Yield was again the biggest winner internationally, seeing +1.28 SD of normalized gains and surging towards Overbought territory.
• Profitability was a close second, as the factor left Oversold space and headed back towards the mean.
• Size also saw a fairly strong upward move, and is now an Overbought factor at +1.45 SD above the mean.
• Value continued to fall deeper into Extremely Oversold territory, sitting at -3.23 SD below the mean.
• Market Sensitivity and Volatility both reside in Extremely Oversold space, with our factor du jour Market Sensitivity falling nearly a full standard deviation over the past week.
• Growth continued to take its lumps, falling out of Overbought space and now sitting near the mean.
• Global Risk (using the ACWI as proxy) popped over 11% in the past week.

Please let us know if you’d like to discuss runaway Beta in more detail and would like to learn how we can help you reduce your exposure to it.

Regards,
Omer