What Is Beta?

Macro Mechanics

The best information we can ever provide investors is the mechanics of how we think about macro conditions over time rather than what we think about them at any particular time.

Consistent with this idea, we present our Macro Mechanics, a series of notes that describe our mechanical understanding of how the economy and markets work. These mechanics form the principles that guide the construction of our systematic investment strategies. We hope sharing these provides a deeper understanding of our approach and ongoing macro conditions.

Thus far in our Macro Mechanics series, we have provided our understanding of the importance and implications of:

• Growth

• Inflation

• Liquidity

• Integrating Growth, Inflation, & Liquidity

Now that we have provided a basic understanding of why these macro variables matter, we will begin bridging how they impact markets and the portfolio solutions that emerge from them. The mechanics we have presented thus far determine the attractiveness of asset returns, which we can collectively call beta. A strong understanding of beta is a foundational pillar for active investing. As such, today, we will discuss our understanding of beta and its drivers.

Beta is typically defined as a measure of how much a stock's price is expected to fluctuate compared to the overall equity market. For example, a beta of 1.0 indicates that the stock's price is expected to move with the market. A beta greater than 1.0 indicates higher volatility than the overall market, and a beta less than 1.0 indicates lower volatility. This concept is often limited to equities; it can be applied to any market. While this is a reasonable definition of beta at the security level, it essentially loses meaning at the asset class level.

At the macro level, we define beta as the expected return for holding an asset at the opportunity cost of consuming or buying other assets as compensation for the inherent risks embedded in the asset's economic biases.

This definition recognizes that the present value of every macro asset, whether it be a stock, bond, or commodity, is at a discount to its future expected value. This discount exists because there is an inherent risk that the investment environment will not favor a given asset. Specifically, assets exist at a discount to their future expected value because they price in the uncertainty of whether growth, inflation, and liquidity will come together in a manner that supports their inherent economic biases. Every asset class’s bias toward growth, inflation, and liquidity outcomes varies. These biases are intrinsic to the construction of each asset or beta. We can summarize each of these biases below:

• Stocks: Equities are designed to benefit from rising nominal growth, falling inflation, and increasing liquidity conditions.

• Credit: Corporate bonds are designed to benefit from rising nominal growth, falling inflation, and increasing liquidity conditions. TIPS & gold offer a somewhat hybrid exposure to stocks and bonds.

• Bonds: Treasuries are designed to benefit from slowing nominal growth, falling inflation, and rising liquidity conditions.

• Commodities: Treasuries are designed to benefit from rising nominal growth, rising inflation, and rising liquidity conditions.

• TIPS & Gold: TIPS & Gold are designed to benefit from slowing nominal growth, rising inflation, and rising liquidity conditions. TIPS & gold offer a somewhat hybrid exposure to commodities and bonds.

We think there are three major features to note here. First, every asset represents a bet on the economy having a specific set of growth, inflation, and liquidity outcomes. Second, for every permutation of growth and inflation, there exists an asset that is designed to outperform in that environment. Third, all assets prefer a rising liquidity environment.

Because all assets are generally priced at a disccount to their long term expected value, they tend to rise on average over time. Addtionally, because they are all packaged with different economic biases, they tend to rise at different times. The combination of these features is extremely beneficial to investors. For every environment where an asset does poorly, there is an asset that does extremely well. Thus, by combining macro assets with different macro baises, we can create portfolios that are largely immune to all changes in growth and inflation, but maintain exposure to liquidy conditions. This is what we at Prometheus call beta, i.e. a long-only portfolio that has no bias towards growth or inflation, and solely bets on the broad expansion of the financial system in the form of liquidity.

For most investors, we think this style of beta portfolio is the preferable way to invest. This is because this approach reduces portfolio risk dramatically, and smooths returns by maintaining a high degree of mechanical diversity. The empirics of this approach are consistent with these mechanics. No single asset has durably outperformed a diversified beta portfolio over long periods of time and macro regimes. Thus, when investors are considering whether to invest in one asset or another, we think this beta portfolio is the starting point and hurdle that an investor needs to consider before placing any individual bets.

The most important understanding and intuition about a beta portfolio is that it is essentially a portfolio that possesses no bets other than the implicit assumption that the expansion of liquidity over time, will support investment assets over cash. Once we have this foundational understanding in place, we can begin to truly evaluate the value of taking active views. If these active views cannot improve or outperform a beta portfolio, they are suboptimal. Indeed, there a host of techniques and strategies to improving and outperforming beta, but it is essential to recognize that a diversified beta portfolio sets a high standrard to begin with.

In our approach to portfolios, we always start with a diversified beta portfolio as the foundation atop which we build our strategies. We benchmark our value based upon the value we can add to beta. For an in-depth look at how we apply this mechanical understanding to active investing, you can check out our ETF Portfolio, which is built upon this foundational understanding of macro markets: