Investors assemble a portfolio of investments that is balanced and can provide them with the best possible returns while minimizing risk. Risk is a huge factor in determining one’s portfolio structure as it greatly influences the gains made or losses sustained. One type of portfolio is the Zero-beta Portfolio. This is a portfolio with zero systematic risk, which is a lucrative feature for many investors. Read on to know more about this type of portfolio and how it works.
What Does Zero-Beta Portfolio Mean?
Investors with a very low-risk tolerance need to minimize investment risks as much as possible. The Zero-Beta Portfolio is created in such a way that has no systematic risk. The expected returns are low and typically match the risk-free rate of returns. This kind of portfolio has no correlation with fluctuations in the market.
In a bull market when stock prices are on the rise, this portfolio is not an attractive option for most investors. With little market exposure, the performance is poor compared to a diversified portfolio. However, in a bear market when prices are on the decline, investors tend to invest in risk-free options or short-term ones to protect their investments. Here a Zero-Beta portfolio may prove to be beneficial.
How Does A Zero-Beta Portfolio Work?
This portfolio gets its name because of the beta of zero systematic risk. Beta is used for measuring a certain investment’s risk due to market fluctuations of a specific index. It essentially assesses the volatility of the investment with respect to the market index.
A greater than one beta indicates greater volatility, while a less than one beta indicates lower volatility. Negative betas indicate a movement of the investment in the opposite direction with respect to the particulate market index. A formula is used for this measurement: Beta = Covariance of Market Return with Stock Return / Variance of Market Return.
Zero-Beta Portfolio Example
In order to understand how the Zero-Beta Portfolio operates in the real world, we need to have a solid understanding of how the measurements and values interact.
Let us take a Zero-Beta Portfolio Example. For the purpose of this example, the stock we are looking at is large-cap. The chosen market index will be Standard and Poor’s 500 large-cap stock index. We will also consider a small-cap stock and choose a corresponding small-cap stock index- Russell 2000. The large-cap stock’s index will be 0.97 while the small-cap stock will have a beta of 0.7. It is also possible that the company has a beta in the negative.
As we know, the formula we need here is: Beta = Covariance of Market Return with Stock Return / Variance of Market Return
If a portfolio manager has an investment budget of USD 5 million, and wishes to assemble a Zero-Beta portfolio against the S&P 500 index, he can consider the following list of investment options:
- Stock 1– with a 0.95 beta
- Stock 2– with a 0.55 beta
- Bond 1with a 0.2 beta
- Bond 2with a -0.5 beta
- Commodity 1with a -0.8 beta
In order to create a Zero-Beta portfolio, the manager should ideally allocate his capital in the following manner:
- Stock 1- USD 700,000 with a weighted beta of 0.133 and taking up14% of the portfolio
- Stock 2– USD1,400,000 with a weighted beta of 0.154, making up 28% of the portfolio
- Bond 1– USD400,000 with a weighted beta of 0.016, making up 8% of the portfolio
- Bond 2– USD1 million with a weighted beta of -0.1, taking up 20% of the portfolio
- Commodity 1– USD1.5 million with a weighted beta of -.0.24, taking up 30% of the portfolio
The resultant portfolio would possess a -0.037 beta which is nearly zero betas.
Features Of A Zero-beta Portfolio
Systematic risk measures the portfolio sensitivity to market fluctuations, but with a Zero-Beta portfolio, there is no influence of this fluctuation and therefore no involved risks. Thus the attraction of the portfolio lies in that it is similar to a risk-free asset.
Separate betas of assets are added and the sum of the weights is factored in while calculating the beta of a Zero-Beta Portfolio. In theory, you can take a variety of independent assets to construct a Zero-Beta portfolio. The price fluctuations for one asset will not influence the other assets.
Hedge fund managers also add various investment options like futures contracts or real estate instruments as substitutes in a Zero-beta portfolio. It cannot reduce risks specific to an asset but can reduce systematic risk.
In a Zero-Beta portfolio the investments are hand-picked so that there are no portfolio value fluctuations due to market movements.
What Is The Importance Of A Zero Beta Portfolio Matter?
While a Zero-beta Portfolio may not seem very lucrative to investors looking for greater returns, they can offer security and stability in terms of no risks and assured returns. Since it is effectively equivalent in value to the risk-free rate of returns, the returns with this portfolio will below. Zero exposure to market movements ensures the lowest possible volatility but also erases the chances of benefitting from any possible market value upswings.
All investors, new as well as experienced, rely on thorough market research while constructing an investment portfolio. A diversified portfolio is generally advised to reduce risks while still ensuring good gains. However, for those who are absolutely averse to any investment risks, a Zero-Beta portfolio might be the best option.