Why low beta stocks perform better
One of the basic fundamental theory on which stock market rests and billions of dollars are being managed is the Capital Asset Pricing Model (CAPM). The theory suggests that return on investment on any stock or mutual fund scheme will depend upon its sensitivity to broader market returns. This sensitivity is better known as ‘beta’. Therefore, a higher beta stock is likely to perform better than the market or a lower beta stock or investment in a longer time horizon. In the shorter duration when the market is falling, you may find lower beta stocks performing better than the rest of the market.
The facts, however, suggest something different from this common wisdom that a higher beta generates better returns in the long run. Many a time, it is the lower beta that has generated better returns.
To understand this, we did a study of the last 10-year returns of different sectors. To highlight our theory that lower beta generates better returns in the long run, we selected two sectors that had similar returns during the given period.
| | Equity Performance (01-01-2009 to 29-03-2019) |
| Sector | CAGR (%) | Volatility | Beta |
| Nifty | 14.08 | 1.14 | |
| Nifty Financial Services | 19.86 | 1.51 | 0.69 |
| Nifty IT | 20.77 | 1.38 | 0.50 |
Both the financial services and IT sectors have performed better than the frontline equity index and have similar returns. Nonetheless, if you check the ‘beta’ of these indices, we see that Nifty IT with significant lower beta has performed slightly better than Nifty Financial Services. They even have lower volatility, which is measured by standard deviation of the daily returns. Ideally, Nifty Financial Services with higher beta should be giving better returns.
The reason for such anomaly lies in the performance of these sectors during the bull and bear phases. We have defined ‘bear phase’ as that phase when the market has fallen by more than 20% from its recent peak. The 'bull phase' is defined as the period when the market kept on increasing before the start of a major fall in the market.
| Bull Phase (Oct 2013 - Sep 2015) Return | Bear Phase (Nov 2010 - Dec 2011) Return |
| Nifty | 30.23% | -24.56% |
| Nifty Financial Services | 38.04% | -32.85% |
| Nifty IT | 31.82% | -9.56% |
The above table clearly shows why lower beta sectors or stocks perform better than the higher beta stocks. Lower beta sectors fall less during the bear phase. During the bull phase, these sectors underperform the higher beta sectors, however, their underperformance is far lower than their outperformance during the falling market.
Therefore, until and unless you are not actively managing your portfolio, it is better to maintain a portfolio of lower beta stocks for a longer period.