Is beta dead in Bursa?

We know that diversification reduces risks. But there is a limit the risks can be reduced. We can only reduce the idiosyncratic risks, or specific risk by having a diversified portfolio of stocks. We cannot do anything about the systematic risks, or the market risks. Interest rates, recessions, financial crisis and wars are examples of systematic risks. Therefore, when calculating a deserved return, systematic risk is what plagues investors most.

Beta is a way to measure the systematic risks in the "capital-asset pricing model" (CAPM). Beta measures a share's relative volatility - that is, it shows how much the price of a particular share jumps up and down compared with how much the stock market as a whole jumps up and down at the same time. If a share price moves exactly in line with the market, its beta is 1; if it rises by 15% when the market rises by 10%, it has a beta of 1.5; but if it rose by only 5%, it has a beta of 0.5. The more volatile a share relative to the market, the riskier it is, according to CAPM. The following link explains the CAPM and the use of beta.

http://www.investopedia.com/articles/06/capm.asp

According to CAPM, the expected return of a security r is given by the formula below:

r = r_f + β*(r_m - r_f)

r_f = Risk free rate

r_m= expected return of the market

β= Beta of the security

(r_m - r_f)= Equity market premium

Rearranging the CAPM equation,

(r-rf ) = α + β*(r_m - r_f)

where α is excess return. If CAPM holds true, α should not be significantly different from 0.

Let us use the CAPM to determine if the stocks in my portfolio set up in January 2013 earns any excess returns from the market. My portfolio can be viewed from the following link:

http://klse.i3investor.com/servlets/pfs/13147.jsp

I will start with Kimlun. In this case we are using the realized return in place of the expected return to check if there is any excess return after the fact.

By plotting the daily returns of Kimlun in 2013 against the returns of KLCI, and fitting the best straight line, the β of Kimlun is obtained from the slope of the line, in this case 2.19. This means the stock price of Kimlun moves 2.2% when KLCI rises 1%. Kimlun returned 26% and the market (r_m)14% for the year 2013. Hence,

(r-rf ) = (26%-3.5%)=22.5%, and

β*(r_m - r_f) = 2.19*(14%-3.5%) = 23% which is quite close to the above

Hence for Kimlun, its return fits in nicely with the CAPM.

The graph below shows the plot of the daily returns of Kimlun against the daily returns of KLCI for the last one year.

Figure 1: Return of Kimlun Vs return of KLCI

How about the other stocks in the portfolio? Are the return behaves according to the CAPM as Kimlun does? What about the portfolio itself? The table below summarizes the Greeks.

Table 1: systematic risks and excess returns

It can be seen that the CAPM doesn’t work at all as the excess return, α, is generally not even anyway near zero.  Kumpulan Fima with β of 1.06, which has approximately the same systematic risk as KLCI, has an α of -16%, whereas Jobstreet which has a lower systematic risk of β of 0.80, has an excess return of 99%. Prestariang which has double the systematic risk at 2,0, has also a very high excess return of 122%. The α of all other stocks, are also significantly different from zero.

The assumed equally weighted portfolio of the stocks has a portfolio β of 1.37 and a return of 52.4%. Hence the excess return of the portfolio is (52.4%-3.5%)-1.37*(14%-3.5%) equals to 35%, also significantly different from zero.

From the realized return of the stocks and the portfolio, it is clear that the CAPM, or the use of β doesn’t really work that well.

So is beta dead in Bursa?