Beta Review: How well is the beta forecast back?

After the Capital Asset Value Model (CAPM) was created in the 1960s and 1970s, financial researchers began to test how well this theoretical model actually worked in the real world.

Between broad computing power and greater data access, the 1980s became an important era for verifying the validity of CAPM as analysts explored the effectiveness of beta in anticipating future revenue.

Surprisingly, the general sensitivity that emerged is that the ability to predict better returns is quite weak.

In the 60 years or more since the advent of CAPM, how much has model and beta expected returns improved over the decades? To find out, we analyzed each firm trading on the NYSE and NASDAQ and built a portfolio of companies based on their systematic risk (beta) using monthly returns and 12-month rolling calculations.

If a firm had a beta below 0.5, it was allocated to a lower beta portfolio. Firms with more than 1.5 betas were assigned to its top beta competitors.

Using these groups, we examined how portfolios worked in subsequent years-both on a medium and market-cap-based basis. Portfolios were restructured according to new beta counts each year.

High-beta portfolio median returns Low-beta portfolio median returns High-beta portfolio market-weighted returns Low-beta portfolio market-weighted returns Percentage of the year in line with CAPM
1970s 14.9% 2.5% 14.3% 3.5% 80%
1980s 13.0% 14.4% 12.1% 18.1% 40%
1990s 18.7% 12.6% 22.6% 13.4% 70%
2000s 15.2% 8.9% 10.7% 5.2% 80%
2010s 14.7% 9.0% 13.3% 12.5% 91%

As it turns out, the 1990s were a terrible time for Beta. On an annualized basis, a low beta portfolio performs an average of 6 percentage points better than its higher beta counterparts over a decade, generating 18.14% vs. 12.12% return.

We then examined the percentage of years that reflected the CAPM forecast on a general basis over decades. In only four of the 10 years has CAPM accurately predicted returns. That is, positive market return years should be consistent with high beta betting low beta portfolios and negative market return years should be consistent with low beta betting high beta portfolios. This means that CAPM has done worse than a random walk during this period and helps explain why researchers of the era were so skeptical about the model.

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But the 1980s were something external. As the decade progresses, beta and CAPM become a better predictor. From 2010 to 2020, CAPM was right in 10 of the 11 years.

In fact, every decade since the 1980s, a higher beta portfolio generates slightly more of a 5 percent point premium annually than its lower beta peers. That is, the high beta portfolio returns an average of 15.53% compared to the low-beta 10.34% return.

That said, the results highlight that beta is not as bad as often predicted for future returns. The 1990s were a terrible time for beta and CAPM, but since that decade, beta has been a good predictor of future returns.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / SK Lim / IEM

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Derek Horstmeyer

Derek Horstmeyer is a professor at George Mason University School of Business, an expert on exchange-traded funds (ETFs) and mutual fund performance. He currently serves as the new director of financial planning and asset management at George Mason and established the first student-led investment fund at GMU.

Jack McCann

Jack McCann is a graduate senior at George Mason University and his B.S. At Mason, he worked one semester as an analyst at the Montano Student Managed Investment Fund, focusing on technology. Upon graduation, McCann will work as Glenloch Legal’s operations manager. In addition, he hopes to build his own financial education business.

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