# A portfolio idea: Zero Beta



## reece55 (21 March 2008)

I think everyone agrees that the last 3 months have been very difficult to navigate for any investor, be that a long term or short term swing trader...... In that vein, I have been giving thought on how to achieve a good return in these types of conditions without risking the house..... Dusting off my portfolio theory textbooks and a bit of investigations, one idea I have come up with that I have been testing lately is what I refer to as a zero beta portfolio. Beta of course is the correlation that your portfolio has to the underlying market and I think we all agree that you don't want that correlation to the market at the moment. Being short on the index of course results in a -1 beta, but has a negative expected return in the long run. So here are the simple rules:

1. The portfolio must consist of at least 10, preferably 20 stocks. Why - simple, diversification to remove stock specific risk. 

2. The portfolio must have equal long and short positions.

3. The initial portfolio must have $0 exposure to any GICS industry - i.e. a short and long exposure in each industry

The rest would really be up to the investor. You could set stop levels on each  short and long pair (i.e. stop loss at say 10%, gain above 20%?). If you wanted to get really technical, as the portfolio moved you can approximate the beta of each stock and hedge any positive or negative beta by selling index options. But the best thing is that this can suit both a fundamental or technical investor - perfect for all occasions.... like your own little pocket hedge fund..... 

Any views???????

Cheers


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## ROE (21 March 2008)

*Re: A portfolio idea*

My portfolio always been 10 stocks or less 
I either increase holding on stocks rather than buy more stocks
If I can find a stock that has much better potential than
the one on my list of 10..I sell one and increase the same amount
on the new stock


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## Sean K (21 March 2008)

*Re: A portfolio idea*

Is this an 'active' portfolio?

I buy and/or sell almost every day. 

Then add day trading - obviously not part of this plan. 

Are there parameters for buying and selling?


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## reece55 (21 March 2008)

*Re: A portfolio idea*



kennas said:


> Is this an 'active' portfolio?
> 
> I buy and/or sell almost every day.
> 
> ...




Hi Kennas
It's more of a fundamental idea than anything else that I am toying with. At present, I am paper trading it and I have been trading fairly regularly (maybe a three pairs opened each week). The buying and selling parameters would depend on what kind of investor you are - in this market, I have actually been using a modified fundamental valuation method which is based on the stability of an entities earnings and debt profile i.e. leverage etc. - those with volatile earnings and high debt are short sold, those with more stable cash flow are bought as a hedge. But you could just as easily adapt it to even a technical analysis system - it is really up to the person running the portfolio.

Stops and profit taking would then be based on risk/return - i.e. I have been using a 10% decline in the pair as a stop, which is 1% risk per pair on the portfolio, with a take profit at at least 15%.

Cheers


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## tech/a (21 March 2008)

*Re: A portfolio idea*

Reece.

While the idea is fundamentally and logically sound as your well aware the markets are----particularly in these times controlled by fear and greed.

Unfortunately both have little regard to fundamental logic.


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## reece55 (21 March 2008)

*Re: A portfolio idea*



tech/a said:


> Reece.
> 
> While the idea is fundamentally and logically sound as your well aware the markets are----particularly in these times controlled by fear and greed.
> 
> Unfortunately both have little regard to fundamental logic.




Mmmm..... I guess I agree and disagree with your comment Tech.... My thought is that the nature of a long/short portfolio, if established with care, negates this "fear market" risk because you are sector and index neutral .....

Couple of examples of some trades that I have run that have proved to be successful:

Merger Trade
Long DXL short IPL - this merger was fairly obvious in timing, as soon as Dyno announced their results I implemented the trade - nice easy money

Debt Issues:
Long EHL and short BOL - not only was this a fundamental play, it was also a technical play, as clearly BOL has been much much weaker than that of EHL. Implemented after EHL's results announcement for a tidy return.

Loan Book:
Long WBC, short BEN. It has been well known that Westpac suffered market share loss at the top of the market because they looked after their loan portfolio, Adelaide Bank on the other hand was chooked full of securitisation and low doc loans.

Valuation
Long BKN, short UGL after the Bradken plunge - Bradken was brutally sold down, whilst UGL remained intact - it was a matter of time before the two came back in line with one another.

Just a couple of relatively easy examples......

Cheers


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## tech/a (21 March 2008)

*Re: A portfolio idea*

Reece.

Fundamentals isnt my thing I'm afraid.
But I guess all you can do is trial it.
Keep some good records and re visit as time goes by.
Wouldnt mind seeing your trades posted here win lose or draw.


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## 2BAD4U (22 March 2008)

*Re: A portfolio idea*

What about the beta of your portfolio?  I will adjust my portfolio depending on the times. ATM I have a beta of less than 1 (about 0.9) but once the market turns I will increase that upto about 1.2+.  Also need to look at the balance of industries that will do well given the economic conditions. At present that leans me towards food and energy with increased holdings in both.


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## reece55 (22 March 2008)

*Re: A portfolio idea*



2BAD4U said:


> What about the beta of your portfolio?  I will adjust my portfolio depending on the times. ATM I have a beta of less than 1 (about 0.9) but once the market turns I will increase that upto about 1.2+.  Also need to look at the balance of industries that will do well given the economic conditions. At present that leans me towards food and energy with increased holdings in both.




2BAD4U, the idea is to have a 0 beta, therefore no correlation to the market at all and take advantage of miss allocation of prices in securities between industries, be that on a technical or fundamental basis. Obviously this is only achievable when you begin the portfolio and as it moves, you could synthetically adjust with index options.

A variant I did consider was a zero beta with macro positions (i.e. short financial and long health care for example), but that really means you have to be right about the industries that will do well in the economic cycle at present.... Plus, I suspect it would lead to an increase in volatility, which obviously I want to minimise....

Cheers

Cheers


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## julius (22 March 2008)

reese - isn't systematic risk proportional to the number of stocks in the portfolio (diversity) ? you lose stock specific risk at the expense of market risk ?


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## reece55 (22 March 2008)

julius said:


> reese - isn't systematic risk proportional to the number of stocks in the portfolio (diversity) ? you lose stock specific risk at the expense of market risk ?




True, but in this portfolio the theory is to eliminate market risk as well, by going short and long in each industry....... So neither stock specific nor market risk, but positive return is the aim......

Cheers


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## julius (22 March 2008)

so if there's no market risk AND no market risk, then you end up locking in the risk free rate of return ?


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## reece55 (22 March 2008)

julius said:


> so if there's no market risk AND no market risk, then you end up locking in the risk free rate of return ?




HAHA... If that were the case, we would just put the money in a bank bill.... LOL

No, I think there would be a variety of expected return outcomes depending on the person controlling the buy/sells, or the strategy. But I guess what I am hypothesizing if that even if you are half good with your picks and you set the right stops/take profits, then you should generate a positive return in any market conditions. Depending on your expected return and portfolio volatility, you could gear the portfolio up conservatively (say 2.5:1 or 2:1) to generate a great return...

As I say, your own pocket hedge strategy....

Cheers


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## happyjack (22 March 2008)

Hi Reese
I just caught on about the avatar, Nice one, Must have seen it a hundred times and it didn't click, getting slow in the old age

happyjack   :silly:


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## reece55 (23 March 2008)

happyjack said:


> Hi Reese
> I just caught on about the avatar, Nice one, Must have seen it a hundred times and it didn't click, getting slow in the old age
> 
> happyjack   :silly:




Hey Happyjack
Well, when I first used the avatar, I didn't think it would be relevant going forward, guess I just like the play on the Enron logo. Amazing how relevant the old Enron story is in light of the recent splurge Wall Streets had on debt, only this time the bankers are the ones caught holding the hot potato....

Back to my idea, Tech, would be happy to post the method on here, I will get back on how to go about it..... After all, live trades are what it is all about.....

Cheers


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## reece55 (25 March 2008)

In light of Tech's comments, I'm going to test my theory live here on ASF...

I haven't calculated the beta yet, but we are sector neutral and net portfolio neutral. The following rules will be applied to the portfolio:

Stop: Maximum 20% loss on pair
Take profit: Arbitrary, but most be above 15%.
Broker Fee: 0.3%

I am not going to apply interest, because the portfolio is probably easiest to achieve on a CFD platform, in which case it at the moment would most likely be interest neutral or slightly negative (depending on gearing and account structure [i.e. some pay interest on deposited margins, others do not]).

Any comments are welcome.....

Cheers


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## peter2 (25 March 2008)

I always support someone trying something different (for them).

How did you select each pair, random?

How will you balance each pair, value or volaltility? 

Have you looked at the chart of each spread? 

Do you know that the spread is trending in your direction? 

Go for it Reece.


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## reece55 (25 March 2008)

peter2 said:


> I always support someone trying something different (for them).
> 
> How did you select each pair, random?
> 
> ...




Hi Peter
Thanks for the friendly comment, just trying to think out of the square in interesting market conditions.

Each pair is picked based on a discretionary method, but basically it factors in a fundamental valuation (modified free cash flow using a DCF) and technicals. The balance is by value, but interesting that you mention volatility. I did consider this, I know for instance that the turtles used such a method. But it's a little hard to gauge IV in this environment in my opinion, perhaps when things cool down I could re-assess this.

The charts of the pair's have not been reviewed individually - my view is that I didn't want to have bias on how far apart each pair has gone, because if I get the fundamental and technicals right, the spread should do what I want it to. However, it would be very ineteresting to examine the spread using T/A - thanks for the tip, I hadn't considered that.

Result for today - pretty boring result today, even though there was wild and sharp volitile conditions today, the portfolio increased by $26!!!! Biggest loser was the Long Westpac and short Bendigo Bank after Bendigo retraced sharply (Pair down 7.38%), best performer was Long EHL and short BOL (Pair up 4.66%).  

Cheers


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## peter2 (25 March 2008)

Your edge in this exercise is your understanding of the fundamentals and how it might effect the stock price. Consider using TA as your timing tool. You are trading the spread so you need to look at the chart of the spread. 

My software charts the ratio of the prices (primitive I know, but illustrative) and I have posted three of the spreads for you. The charts are very interesting. 

Unless you have done plenty of research to backup up your figures I will suggest that by allowing your losses (20%) to be bigger than your profits (15%) means that you will have to be correct at least 60% to breakeven. Do you know that you are this good? 

If your wins are greater than the losses then you need 50% or better to profit.

[An example of how research/backtesting helps in constructing a winning strategy.]


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## reece55 (25 March 2008)

peter2 said:


> Your edge in this exercise is your understanding of the fundamentals and how it might effect the stock price. Consider using TA as your timing tool. You are trading the spread so you need to look at the chart of the spread.
> 
> My software charts the ratio of the prices (primitive I know, but illustrative) and I have posted three of the spreads for you. The charts are very interesting.
> 
> ...




Thanks Peter, great input here mate, appreciate it.... The three you have chosen look to be the pairs that have moved a great distance in percentage terms lately (say in the last 12 months). Particularly with EHL and BOL, I think there is a lot more scope to move. However, looking at BEN:WBC and OSH:ROC, boy have they already moved a great distance lately - but I chose them based on my methods, so I will see how we go. 

I think upon reflection, I will actually reduce the stop down to 10% and reduce the take profit down to 12%. This way I can still have a less than 50% win rate and come out on top.

By the way, I actually have a US version of this type of system on KaChing here. I am third out of any member on the site for the month so far, with a 4% outperformance against the S&P 500 for the Q with a bit over a 6% return. Boy I wish they had this site for Australian stocks, it would be a god send!

Cheers


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## peter2 (25 March 2008)

I had a quick look at your US portfolio. I shouldn't have to tell you that you have let two longs (CME, GOOG) get way out of control. It doesn't matter what short they are associated with. Your results should have been much better. 

Work in progress I assume. Good luck with it.


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## reece55 (25 March 2008)

peter2 said:


> I had a quick look at your US portfolio. I shouldn't have to tell you that you have let two longs (CME, GOOG) get way out of control. It doesn't matter what short they are associated with. Your results should have been much better.
> 
> Work in progress I assume. Good luck with it.




Yeah Peter, the US one is a work in progress....... It was actually where the idea stemmed from when I was messing around, but I will be opening another portfolio on that same site that adheres strictly to a pair stop and take profit methodology.....

Looks like you have a bit of knowledge in this area, do you run any portfolio's in a similar fashion? Any insights that you have that might assist me in my journey?

Cheers


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## peter2 (25 March 2008)

I have no experience in this style of trading but understand what you are trying to do. It is another method of avoiding the high daily volatility while ensuring that you are invested in the markets. 

You will need to use leverage to get bigger profits, this means cfds or options US stocks) 
Do as much paper trading as you can to fully understand what can go wrong. Use TA to time your entries into spreads that you have identified. 
Work out the right risk/reward for your W%.
Exit trades that start losing even if it is one of a pair. Replace it with another stock same sector.
Short a poor stock against its sector (EFTs) if you have strong ideas about one stock. 

I have said it before, there are unlimited opportunities out there every day for you. Get into them.


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## reece55 (25 March 2008)

peter2 said:


> I have no experience in this style of trading but understand what you are trying to do. It is another method of avoiding the high daily volatility while ensuring that you are invested in the markets.
> 
> You will need to use leverage to get bigger profits, this means cfds or options US stocks)
> Do as much paper trading as you can to fully understand what can go wrong. Use TA to time your entries into spreads that you have identified.
> ...




Thanks Peter once again for your comments....

My idea would be to get plenty of back-tested data before playing the portfolio "live", because the aim would be as you have said to use leverage to achieve larger profits. You can't do this until you are confident in your method.

Your comments have given me something to think about, particularly the exiting where even one side of the pair has a negative return (that is something I had not considered, because so far I have been focusing on net profit or loss on the pair in aggregate, regardless of the inter pair valuation) and shorting a stock against the ETF...

Cheers


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## martinad (9 May 2016)

I need to construct zero beta portfolio ( Blacks - CAPM) via excel, could someone help me?

Thanks in advance!

Best regards!


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