U.S. equity markets are sitting at all-time highs driven by some of the riskiest stocks in the market. Theory says high-risk stocks should have higher returns than less risky stocks. In reality, the riskiest stocks have tended to underperform over the long term.

Beta as a risk metric

Beta is a metric that measures an investment’s risk relative to the overall market. A beta of 1 indicates risk commensurate with equity markets, while above or below 1 indicate more or less risk, respectively. Simply put, higher beta normally equals more risk.

Conventional investment theory says that portfolios must provide more return as the level of risk increases because investors should require compensation for taking on more risk. In reality, this relationship has not been linear. Further, as investors add more risk the amount of compensation they receive is less than the additional risk taken. Notably, when ranked by beta, the top quintile (top 20%) of stocks in the S&P has underperformed over the long-term relative to the overall index.

Excess return is a measure of the performance that an active manager produces above or below a benchmark or index. Ideally an active manager would be able to beat the index without taking more risk than an index fund. This would be potential evidence of skill by the active manager.

Guided by history (including the drawdowns)

Recently, the U.S. large cap market has been driven to new record highs by a small number of mega-cap stocks. These mega-cap stocks have pushed U.S. valuations higher relative to both history and versus foreign stocks.

Historically, we’ve seen certain time periods in which some investment managers took high-beta positions and generated spectacular gains only to post significant losses when market leadership shifted. There have been past instances where higher-beta investments have provided substantial positive excess returns—namely the “Tech Bubble” of the late 1990s and of course the past two-and-a-half years with “Magnificent 7” leadership. Still, even accounting for these periods, high-beta stocks have simply not kept up with the S&P 500 Index when long-term compounding includes the drawdowns.

MAR ratio

Now, we examine the past 10 years of returns for the highest-beta U.S. large-cap money managers to see how they fared when using a risk adjustment that compares the managers’ returns to their portfolio’s biggest drawdown. Given that bear markets (declines of over 20%) do occur and should be expected to occur again in the future, it is important to understand how a money manager’s investment strategy may fare in such an environment. By using a metric such as the MAR ratio1, it is possible to compare the performance pattern of a high-beta manager to the S&P 500 Index to determine whether the upside experience is sufficiently better to warrant the downside experience associated with the strategy. Intuitively, a higher MAR ratio is better.

The good news for the highest-beta quintile of active U.S. large-cap managers is that they managed to outperform the S&P 500 Index over the past 10 years. The bad news is that their MAR ratios are worse than those of the index and this might not bode well for future environments when markets provide returns that are more typical of long-term averages when compounding includes drawdowns.

Buyer beware: Beta is just risk

History suggests that we are in an environment where excess risk is being rewarded in equity markets. While beta is a factor that can sometimes outperform, historical results have not shown this to be a persistent source of performance. Whether you’re looking at an exchange-traded fund, mutual fund, or another investment strategy at this time, it would be wise to consider the level of beta/risk in that investment—even popular passive index investment have become notably concentrated and thus riskier due to market capitalization weighting. We believe investors should focus on portfolios that can benefit from security selection and factors—value, quality, momentum, and low volatility that have historically produced long-term excess returns while being less dependent on “risk on” market sentiment.















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