SPHB - SPHB: Extra Returns When Timed Properly

2023-06-22 02:42:09 ET

Summary

• High beta stocks can provide leverage-like effects on returns, performing well during market upswings and worse during downturns.
• The Invesco S&P 500 High Beta ETF is a good investment during volatile market rebounds, using the VIX as an indicator.
• When the VIX is above 20, but below its level from 20 days ago, buy SPHB; hold until the VIX rises above its level from 20 days ago or falls below 20.

The Invesco S&P 500 High Beta ETF is an excellent tactical tool for investing…but only some of the time. At other times, it is completely the wrong ETF to own. Overall, I give it a BUY rating provided you understand when to hold and when to fold.

SPHB Methodology

The S&P 500 High Beta Index ( SPHB ) takes the 100 stocks in the S&P 500 which have the highest beta over the past 12 months. Beta measures the sensitivity of stock movements compared to the S&P 500. High beta stocks generally have high volatility, although they are not the same thing.

• High volatility is where prices move around a lot.
• High beta is where prices move around a lot while trending with the overall market.

To illustrate, First Solar ( FSLR ) and Mastercard ( MA ) both have a beta of roughly 1. But FSLR has a volatility measure that is more than twice as large as Mastercard.

That being said, there is a high degree of overlap between the two concepts. High beta is a fair, although imperfect, proxy for high volatility. Moving on.

High Beta and Market Cycles

As you might expect, high beta stocks can provide a leverage-like effect on returns. When the market is making a sharp move upwards, you might expect to gain a little extra return. When markets drop, you may lose more than the market.

• Does this mean that if market have a long-term upwards bias, you will receive higher than market returns over the long-term?
• By holding stocks with a beta of 3, does this mean that if the market returns 7% long-term, then you should receive 21%?

No! Absolutely not.

For one thing, beta is a number which is calculated from trailing returns. Beta can change over time. Just because a stock had high or low beta does not mean it will stay that way. Look at the fluctuating beta of Caesar's Entertainment since 2016. It went from very low beta to extremely high.

Now, even if this relationship was static, the one-year beta is calculated from daily returns. This doesn’t translate into long-term returns. Think of those triple-leveraged daily return ETFs.

If this is true, then what is the point of a high beta ETF, and why do I recommend holding it at various times?

Analyzing the Data

The following might get a bit complicated, but there is a valuable piece of insight here. To determine when this portfolio of high beta stocks out-perform, I will construct a market-neutral portfolio.

• The long portfolio will have the same methodology as SPHB.
• The short side will be the cap-weighted S&P 500 or the SPY ETF.

When the portfolio goes up, this means that high beta is out-performing the market. When the portfolio goes down, it means that the market is out-performing high beta.

Do you notice any patterns? The fund shoots up and out-performs the market by a lot during the initial bull rally after a crash. This lasts for about 12 – 18 months.

After a year or so it starts to perform the same or worse than the market. Look at the overall returns between the green circles. And during market crashes (just before the green circles) the relative performance of high beta is much worse.

Creating Tactical Rules

When markets are calm, as we see in the middle of a bull market cycle, high beta stocks slightly underperform. Therefore, our first rule would be to stay out of high beta stocks (and this ETF) during calm markets. How do we determine this? A quick and dirty method is to use the VIX.

• When VIX is less than 20, avoid SPHB

Now we are exposed to volatile markets, both to the upside and the downside. If we were to invest in a high beta portfolio when the VIX was high, we would get both the good and the bad. Our system would look something like this.

We only want the volatile upswings and not the downswings. The way I quantitatively separate upswings from downswings is to use the VIX once more. When the VIX is above 20 but is on a downward trajectory from what it was 20 days ago, this is usually a volatile rebound in the market.

I have circled numerous examples on the chart where the VIX is above 20 and declining from where it was 20 days ago (bottom of chart). These almost always show you where the market is rapidly moving upwards following a correction or a crash (upper part of chart). This is precisely the time you want to be invested in a high beta ETF such as SPHB.

Backtesting the System

To show simulated performance of this strategy, I have created a simple backtest.

• If the VIX is below 20 or if the VIX is higher than what it was 20 days ago, invest in the S&P 500.
• Otherwise, invest in high beta stocks.

The goal is to catch some extra gains with high beta when the market is rebounding. Since 1999 this strategy would have returned 11.63% CAGR. The first chart compares it to the SPY and the second chart to RSP.

Summary

High beta stocks make good holdings for 12 – 18 months following a major market crash...and for a few months following a minor market pullback. To determine when to buy, look at the VIX. When the VIX is above 20 but below the level it was 20 days ago, buy SPHB. Hold it until either the VIX rises above where it was 20 days ago or if the VIX falls below 20. Then close your position and go back to investing in a broad market index.

The trade for today? Wait. The VIX is around 13 - 14. Wait until it rockets upward well above 20 and then falls from where it was 20 days ago. That's the time to buy SPHB. Later...but not right now.

There are risks to tactically trading SPHB. If the strategy is wrong, your returns will typically go down further than the market. But the potential for a little extra gain is worth it in my view provided you understand the beta risk associated with such a strategy.

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