The Betas They Are Changing

Asset Management MARKETING COMMUNICATION II

MAY2020 The betas they are changing ....

The Analytic Investors team, "If your time to you Wells Fargo Asset Management Is worth savin' Then you better start swimmin' Or you'll sink like a stone For the times they are a-changin' " -Bob Dylan

The beta of a stock or portfolio is a widely used measure of risk-capturing the sensitivity of the security to "market wide movements:' Regardless of the source of the movement of the market, this measure captures what the market and the security have in common. A security that has low beta is described as having low sensitivity to the market and vice versa.

It is important to remember that what this measure actually captures is the commonality between the factors that drive the market and how these same factors affect the security in question. Since what drives the market changes over time, the beta of a security will also change over time. The below chart shows that the beta of the average oil stock was low during the credit crisis but has risen more recently, indicating that the movement of this sector has more in common with what is driving the market than it did during the prior decade. Also shown in this chart is the beta of the bank sector-high during the credit crisis but much lower recently.

Figure 1: Barra predicted beta-banks & energy sectors

1.8 80 ~ E 1.6 60 :::l ~ .c ro 1.4 40 ...., ...., C (lJ 0 .D E -0 1.2 20 (lJ r-i t '6 1.0 0 ~ 0.. ~ 0.8 -20 ro CD 0.6 -40 -o ~ -60 3

0.2 -80 r-- CX) CJ) CJ) N M s:i- L{) \D r-- CX) CJ) 0 0 N M s:i- L{) \D r-- CX) CJ) 0 CJ) CJ) CJ) CJ) 0 0 0 0 0 0 0 0 0 N 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 N N N N N N N N N 0 ~ ~ ~ ~ N N N N N N N N N N N N ::,: (lJ .c Li (lJ >, _,_; 2-, >, .c Li c _,_; di 2-, .c .D c Li 0 di C ro = Li ~ (lJ (lJ tl C (lJ (lJ tl 0.. :::l :::l .!2, 0.. :::l :::l ro '§. .!2, (lJ :::l 0. ~ (lJ ro LL (lJ :::l ~ LL z 0 <( 2 ro 0 0 <( 2 <( ro 0 V) <( LL 2 V) 2 - 2

Source: Analytic Investors, Barra, and MSCI

FOR PROFESSIONAL INVESTOR USE ONLY-NOT FOR USE WITH THE RETAIL PUBLIC Because what drives the market changes, the beta of securities will, by definition, also change over time-even if the line of business and strategy of the company itself does not change. If a new factor arrives in the market, there is no guarantee that the beta of a security will remain unchanged-or indeed, there is no guarantee that a low-beta security will remain low beta.

One measure of the rate of arrival of new factors is the correlation of betas over time. If the factors that drive the market are unchanged, then the beta will continue to be stable and unchanged. In contrast, the arrival of a new factor has the potential to dramatically change the beta of securities, resulting in low correlation between the betas from one period to the next-if beta is measured over a short enough period to reflect this change.

Below we show the correlation on a monthly basis of beta predicted by using the Barra Global Equity Model. The month-to-month correlation is computed as a rank correlation, so the measure as reported here is not sensitive to outliers.

Figure 2: Barra predicted beta auto-correlation

1.0

0.9

C ·.;:::;0 0.8 "' ~ 0u ...,b 0.7 ::,

0.5

Sources: Analytic Investors and Barra. Note: The y-axis, auto-correlation, measures the pace of change from month to month. Data covers April 1997 through April 2020.

There is no doubt that the changes we are seeing regarding the estimated beta of stocks is unprecedented. In some ways, this is not surprising, as the arrival of the coronavirus pandemic was truly an unknown unknown, and the changes reflect the importance of this new factor, as well as the investment community's estimation of this factor's impact on the risk of each company. The change is probably epitomized by comparing the change in the risk profile of The Walt Disney Co. versus Netflix, Inc. Both companies are in the entertainment industry. The former reflects an institution with large amounts of intellectual property and physical assets, whereas the latter is a relatively recent producer of on-screen entertainment. The big difference, however, is that the Netflix business model is less susceptible to social distancing. This is reflected in the evolution of the beta of these securities over the past few weeks. Given their respective business models, it is not surprising that the beta of Netflix dropped and the beta of Disney rose over this same period.

2 Figure 3: Predicted beta-Disney & Netflix

1.80 Disney 1.60 Netflix April2020 1.40 May2019 1.10 ro t: 1.71 .D -cJ 1.20 Q) t 'a 1.00 ~ Cl. ~ 0.80 ffi Disney CD 0.60 May2019 Netflix 0.94 April2020 0.40 0.83

0.20

CJ) CJ) CJ) CJ) CJ) CJ) CJ) CJ) 0 0 0 0 N N N N 5 5 5 5 5 5 5 5 0 0 0 0 N N N N N N N N N N N N >, Q) >, 01 .,_; cJ ..c ro C Cl. > Q) c:: ..ci .§_ :5 :::, t 0 Q) .2, <( Q) 0 0 ~ ~ 2

-- Disney - Netflix

Sources: Analytic Investors and Barra

Only time will tell whether these changes are permanent or transitory. History, and Bayes theorem of probability, are probably our best guides to the future:

Initial belief plus new evidence= new and improved belief

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