Not All Risk Is Rewarded

 PowerShares S&P 500 High Beta (SPHB) targets some of the riskiest stocks in the S&P 500 Index in an attempt to boost returns during bull markets. However, these stocks will likely lag during market downturns. Investors in this fund should be prepared for a bumpy ride and have a high tolerance for risk. Although it is not suitable as a core portfolio holding, this fund could come in handy for those speculating on a quick rise in prices.

Beta measures a stock's sensitivity to movements of the market. For example, a stock with a beta of 1.5 should appreciate 1.5% for each 1% increase in the value of the market and shed 1.5% for each 1% decline in the market, at least in theory. All else equal, we would expect high-beta stocks to have higher risk and higher returns than the market. But this is not quite what we find in practice. High-beta stocks have historically offered lower risk-adjusted returns than their less-volatile counterparts, suggesting that the market has not offered adequate compensation for this incremental risk.

Leverage aversion may help explain this anomaly. Investors may be unwilling or unable to use leverage to achieve their return objectives. In order to boost their returns, they might overweight more-volatile and higher beta stocks, which theory predicts should outperform in a rising market. Their collective bet on these volatile stocks may cause them to become overvalued. Investors may also overpay for volatile stocks, which offer a small chance of a high payoff, similar to a lottery ticket.

With its focus on higher-beta securities, this fund may deliver less-attractive risk-adjusted performance than the market over the long term. Consequently, it is most appropriate as a short-term trading vehicle.

Since the backdated creation of the index in 1991, it has returned 9.6% per year annualized, compared with 10.0% for the S&P 500 Index, with a volatility of 29%, compared with 15% for the S&P 500 Index. That is slightly less return with a lot more risk. In live performance since inception of the ETF in May of 2011 through mid-May 2014, this ETF has returned 9.2% annualized compared with 14.2% for the S&P 500 Index. The high-beta index tends to do better during rising stock markets that are not exceptionally volatile.

Fundamental View
According to the capital asset pricing model, stocks with greater nondiversifiable risk should offer a higher expected return as compensation. In 1972, Michael Jensen, Fischer Black, and Myron Scholes found that the relationship between market risk (captured by the capital asset-pricing model beta) and return was not as strong as expected, meaning that there was little extra reward for bearing risk. Since then, several studies have corroborated these findings and found a similar relationship using volatility as a measure of risk.

Historically, stocks with high volatility have traded at a premium to stocks with low volatility. Intuitively, this makes sense as higher-growth stocks such as technology or consumer discretionary stocks tend to be more volatile than slow-growth utilities or consumer staples. Stocks in the high-beta index have an expected long-term earnings growth of 12% compared with 10% for the S&P 500 Index. Because of their abundant growth opportunities, stocks with high beta often have lower dividend payout ratios and dividend yields than more stable stocks. Indeed, the dividend yield on this fund is 1.4% compared with 2.4% for the S&P 500 Index. With bond interest rates depressed in the wake of the financial crisis, many yield-seeking investors have piled into low-volatility and dividend-orientated equity strategies. This newfound demand has had an impact on valuations, and low-volatility stocks now trade at a premium relative to high-beta stocks on measures such as price/earnings.

High-beta stocks' greater volatility may be explained by the fact that they are of lower quality. Only 12% of the assets in the S&P 500 High Beta Index are invested in stocks with a wide moat (Morningstar's assessment that a firm enjoys a durable competitive advantage) and 31% is invested in stocks with no moat. That compares unfavorably to the S&P 500 Index, which has 48% in wide-moat stocks and 9% in no-moat stocks. In addition, the fund has an average return on invested capital of 9% compared with 14% for the S&P 500 Index.

Leveraging up the S&P 500 Index might yield better risk-adjusted performance than this fund. For example, a 100% position in this fund would result in a beta of about 1.8. That same beta could be achieved with a 60% position in ProShares UltraPro S&P500 (UPRO), which attempts to provide 3 times the daily return of the S&P 500 Index, with the remainder in cash. However, investors would need to frequently rebalance this mix. Typically, we do not recommend such products due to their high volatility. Since its inception in May of 2011, the fund returned 9.2% with a volatility of 26% while a weekly rebalanced 60% position in UPRO would have returned 19.8% with a volatility of 29%.

Portfolio Construction
This fund follows the S&P 500 High Beta index, which starts with all of the stocks in the S&P 500 Index and ranks them according to beta relative to the index over the past year. Beta is calculated as the slope or sensitivity of daily changes of a stock's price to the changes of the index over the past 252 trading days. The 100 stocks with the highest beta are included in the index and are weighted according to each stock's contribution to the sum of betas. In other words, the stock with the highest beta receives the greatest weighting in the index. Turnover was 65% in 2013, while the corresponding figure for the S&P 500 Index was only 4%. Investors should expect high turnover in the future. Not only will the individual stocks that have the highest beta change over time, but because the index is not market-cap-weighted, changes in share prices will likely cause turnover. Non-market-cap-weighting also gives the fund a mid-cap tilt. Its average market cap is only $18 billion compared with the $68 billion for the S&P 500 Index. No constraints are placed on sector exposure. Relative to the S&P 500 Index, the fund currently overweights consumer discretionary, financial, and energy stocks, and underweights the health-care, consumer staples, and technology sectors. However, these sector weightings can change over time depending on market forces. The index is rebalanced quarterly starting on the third Friday of February. The fund follows a full replication approach.

Fees
At 0.25%, this fund is lower in cost than many other strategic beta funds and is reasonable for this strategy. However, the fund's high turnover can increase its transaction costs. Over the past year, the fund lagged its index by slightly more than the expense ratio.

Alternatives
This is the only ETF that specifically targets high-beta stocks. However, small-cap stock funds also tend to have a high beta.  IShares Russell 2000 ETF (IWM) has had a beta of about 1.2 over the past 10 years. That ETF charges 0.24%. Speculative traders might also consider using a leveraged fund, although we caution buy-and-hold investors against this approach.

Investors interested in this fund might also consider momentum and low-volatility funds. IShares MSCI USA Momentum Factor (MTUM) charges 0.15% for exposure to stocks with strong recent price appreciation, measured as the average of six- and 12-month momentum normalized by volatility and lagged by one month.

For those looking to control volatility,  PowerShares S&P 500 Low Volatility (SPLV) (0.25% expense ratio) and  iShares MSCI USA Minimum Volatility (USMV) (0.15% expense ratio) might be worth considering. SPLV targets the 100 least-volatile stocks from the S&P 500 Index and weights its holdings by the inverse of their volatilities. However, it can make large sector bets. In contrast, USMV anchors its sector weights to a market-cap-weighted benchmark. It considers the correlations between stocks in addition to their standard deviations to construct a portfolio that minimizes volatility.

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