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The same should be done for beta. While the beta coefficient measures a non-diversifiable risk, you can protect against large swings in your overall portfolio by choosing investments that have negative, low, moderate, and high betas. Keep in mind that a stock could have a volatile price and still have a low beta if the volatility isn't correlated with changes in the market.
Also, because beta is based on historical returns, an asset's beta may change over time. While beta measures how an investment may change with the market, alpha measures how well an investment performs relative to the market. They can be used together when researching investment opportunities. Beta is actually a vital component of the capital asset pricing model CAPM. The CAPM formula can be used to estimate the expected return of an asset based, in part, on its beta. This can then be compared to the asset's actual return to see if it generated alpha — or beat its benchmark without taking on additional risk.
It could be important to consider alpha and beta in tandem when you're reviewing investment opportunities. Bortnem shares a simple example of why:. Predicting how much an investment — or your entire portfolio — may move when the market is up or down can be an important component of investing.
If you don't want to experience big swings, you could look for options that have a low beta. Or, hedge against high beta investments with investments that have a negative beta. If you're not as risk averse, you could look for options with a higher beta that could lead to larger returns. But be careful, a high beta can also mean bigger losses. Also, remember that beta doesn't measure factors that may be specific to a single company or asset.
It can be helpful in building your portfolio, but you want to consider beta within a larger context and only as one once piece of analysis. Back to Top A white circle with a black border surrounding a chevron pointing up. It indicates 'click here to go back to the top of the page. Credit Cards Angle down icon An icon in the shape of an angle pointing down.
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Event-driven investing strategies are typically used only by sophisticated investors, such as hedge funds and private-equity firms. Event-driven investing "lost on average 1. This article about investment is a stub. You can help Wikipedia by expanding it. From Wikipedia, the free encyclopedia. History [ edit ] Event-driven investing "lost on average 1. Barclay Hedge. Retrieved May 8, Merger Arbitrage Limited. Retrieved Retrieved 19 December
Ultimately, an investor is using beta to try to gauge how much risk a stock is adding to a portfolio. In order to make sure that a specific stock is being compared to the right benchmark, it should have a high R-squared value in relation to the benchmark. R-squared is a statistical measure that shows the percentage of a security's historical price movements that can be explained by movements in the benchmark index.
When using beta to determine the degree of systematic risk, a security with a high R-squared value, in relation to its benchmark, could indicate a more relevant benchmark. One way for a stock investor to think about risk is to split it into two categories. The first category is called systematic risk, which is the risk of the entire market declining. The financial crisis in is an example of a systematic-risk event; no amount of diversification could have prevented investors from losing value in their stock portfolios.
Systematic risk is also known as un-diversifiable risk. Unsystematic risk , also known as diversifiable risk, is the uncertainty associated with an individual stock or industry. For example, the surprise announcement that the company Lumber Liquidators LL had been selling hardwood flooring with dangerous levels of formaldehyde in is an example of unsystematic risk.
Unsystematic risk can be partially mitigated through diversification. If a stock has a beta of 1. A stock with a beta of 1. Adding a stock to a portfolio with a beta of 1. A beta value that is less than 1. Including this stock in a portfolio makes it less risky than the same portfolio without the stock. For example, utility stocks often have low betas because they tend to move more slowly than market averages. A beta that is greater than 1.
For example, if a stock's beta is 1. Technology stocks and small cap stocks tend to have higher betas than the market benchmark. Some stocks have negative betas. A beta of Put options and inverse ETFs are designed to have negative betas. There are also a few industry groups, like gold miners, where a negative beta is also common.
The beta coefficient theory assumes that stock returns are normally distributed from a statistical perspective. However, financial markets are prone to large surprises. A stock with a very low beta could have smaller price swings, yet it could still be in a long-term downtrend. So, adding a down-trending stock with a low beta decreases risk in a portfolio only if the investor defines risk strictly in terms of volatility rather than as the potential for losses.
Similarly, a high beta stock that is volatile in a mostly upward direction will increase the risk of a portfolio, but it may add gains as well. It's recommended that investors using beta to evaluate a stock also evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio. While beta can offer some useful information when evaluating a stock, it does have some limitations.
Beta is useful in determining a security's short-term risk, and for analyzing volatility to arrive at equity costs when using the CAPM. However, since beta is calculated using historical data points, it becomes less meaningful for investors looking to predict a stock's future movements. Beta is also less useful for long-term investments since a stock's volatility can change significantly from year to year, depending upon the company's growth stage and other factors.
State Street Global Advisors. Lumber Liquidators. Quantitative Analysis. Risk Management. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. Table of Contents. What Is Beta? Then, we explain how hedge funds or other professionals are using these strategies and how investors can gain exposure. The article concludes with a summary of the analysis and suggestions for further reading. Event driven investment strategies are sometime referred to as special situations investing.
These terms are interchangeable, but for this article, we will simply refer to EDI. In his book Security Analysis , Benjamin Graham offers this definition of special situations :. Convention has not jelled sufficiently to permit a clear-cut and final definition. In the broader sense, a special situation is one in which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance.
The aim of event driven investing is to produce consistently high risk-adjusted returns that do not correlate with the market. The investment manager directs their focus to analysing the change to a stock price due to the event. This is in contrast to a traditional approach, which focusses more on analysing and researching company earnings or dividend streams. The trader can achieve this low correlation by taking advantage of a temporary mispricing, which is less sensitive to movements in the broader equity market than traditional long-only equity investments.
Depending on the type of event, the stock price of a company fluctuates during this period of change. As such, event driven strategies attempt to exploit this stock price volatility. Event driven funds and traders invest in almost all asset classes. Most notably equities, fixed income instruments and derivatives. These products can be liquid or thinly traded and in any geographical region. The combination of products is boundless and subject only to the imagination of the portfolio manager.
Yet despite this variety, the strategies that one concocts may still fall under the umbrella of event driven. Merger arbitrage risk arbitrage is the most well known of all the event driven investment strategies. In the standard merger arbitrage strategy , the trader purchases stock that is subject to a takeover or merger. The discount to the offer price is the spread. The spread is the profit the trader hopes to collect. Sometimes an offer contains acquirer stock as payment.
The trader now has to short acquirer stock in the offer ratio to lock in the value of the spread. These managers speculate on transactions that have not yet had an official announcement. Different managers have rules as to what stage of the merger process they can initiate an investment.
A particular variant of the merger arbitrage strategy proposes investing in only the most certain and safest of deals. These deals have a slender profit margin with a tiny risk of losing a large part of the investment. Merger Arbitrage Limited has many articles with examples relating to merger arbitrage on this website.
Thus, the offer premium is This equates to a 2. The skill of the manager is not only in avoiding deals that might fail but also in finding deals that have disproportionately high spreads in relation to the potential loss in the case of deal failure. Through detailed analysis, the investment manager attempts to gauge the severity of the drop in the stock price following deal cancellation.
However, if a deal was to fail, this in itself creates a new event and opportunity for profit. Some arbitrageurs may short a stock on the way down following a deal break announcement. Subsequently, if this drop is in excess of what the manager considers a fair price, the manager may then go long to stock and wait for a bounce.
This strategy is considerably more risky than standard merger arbitrage. For more risks and deals complexities, we advise the reader to peruse previous Merger Arbitrage Limited articles such as deal extension risk. In the example above, maybe because of regulatory issues deal closure takes 12 months instead of 6 months.
This halves the return and makes the investment pay the same as holding cash. Deals such as those in protected industries energy or telecommunications for example , tend to take longer to complete, as do deals involving multiple regulatory agencies from different countries. However, these factors are often known at the beginning so it is the unexpected delays such as the FTC asking for more information via a 2 nd request which can destroy the profitability of a trade. On top of this, the event driven investment manager must consider dividend payments.
In the case of a stock offer, the portfolio manager must also consider the costs of borrowing the acquirer stock. This may sound complex, but we have constructed a merger arbitrage spread calculator to do this for you. For added complexity, professional arbitrageurs can use bonds to take advantage of the yield discrepancy between the two companies.
Dividend arbitrage is a less common activity that an event driven manager may implement. For example, a company may raise new equity capital and use a different class of stock. This new stock class may not be eligible to receive dividends. The trader attempts a simultaneous purchase of the newly issued securities and shorts the existing securities at a price differential that exceeds the potential dividend and stock borrowing costs.
If a company decides upon a change in its corporate strategy, it may decide to spin off a subsidiary to shareholders. Spinoffs tend to prosper following the separation, as previously the business unit did not fit well with the parent company. A dedicated management team usually has the latitude to operate more freely as a separate company. Investors analyze the spinoff company and the post-spin parent to see if the combined value is greater than before.
This provides the rationale for making an investment or not. Investors also look for spinoffs after the event that trade at a discount. There are times when a parent company may choose to list the spinoff on a different national exchange. This may happen because of geographic proximity. Ownership of a foreign security by an investment fund may be restricted as per its own investment guidelines or domestic regulations. If this causes the spinoff to trade at a discount, local investors will be able to profit from the pricing inefficiency.
However, spinoffs are less well known. When a company raises capital by way of a renounceable rights issue, the event driven manager makes a simultaneous purchase of the rights and shorts the existing stock. The price differential must exceed the amount required to subscribe for the newly issued shares and stock borrowing costs.
Sometimes a firm needs cash, and as a last resort, they decide to issue equity at a large discount to the current market price and dilute existing shareholders. Buyers in this situation are generally qualified institutional investors who can buy a private placement. These new shares are subject to a lock-up arrangement. This restricts sale of the stock for a fixed period. However, immediately following the announcement, buyers of this new stock start shorting the original stock to lock in the price difference, or spread.
The manager can employ additional financial products such as derivatives to accomplish the hedge. The key here is speed, as following the deal announcement it completes rather quickly. Capital Structure Arbitrage takes advantage of mispricing within various securities of the same company, typically in a period of financial stress. The distressed investors assess what each class of securities should be worth, and buy the securities that seem the most undervalued.
Distressed securities are often corporate bonds, bank debt and trade claims of companies that are in some sort of distress, such as bankruptcy. However, rather than go through bankruptcy, a company can go to its banks, stock and bondholders and propose a plan to recapitalize the company.
Usually, this dilutes the equity and forces the bondholders to take a small loss. Since it is voluntary, creditor committees negotiate the result with the company, and investors try to buy the securities that are the most undervalued. After a default, distressed investors analyze the value of the company and its liabilities. They look for the class of securities in the bankruptcy pecking order that the company is unlikely to repay in full.
The owners of that class of securities will likely control the company post-bankruptcy, and will be able to propose a plan to recapitalize the company, replacing the old securities with a new security class. Senior securities will receive payment close to a full amount, whereas junior securities may get little if anything.
Investors seek to capitalize on the subsequent momentum caused by an unexpected revelation made during the earnings announcement. A decline in earnings may lead to a downgrade in either stock or credit an encourage traders to short the stock. The event driven manager attempts to profit from price movements resulting from changes in shareholder bases.
In order to maintain the correct weighting for an index-tracking product, the portfolio must include new index entrants. Following a merger or bankruptcy, or some other unknown reason a given stock may leave a given index. The replacement stock will often see its price rise as passive investment managers scramble to maintain the correct index weighting and minimize tracking error. Most indexes have clearly defined rules, which enable the manager to know in advance what stock are likely to be the next replacements.
However, the timing of when that stock moves into the index is unknown. When hurricanes threaten to damage, investors estimate the likely losses. During this period, the volatility of insurers and reinsurers stocks increases dramatically as investors take positions. Event driven managers can also trade catastrophe bonds. Some specialized hedge funds offer industrial loss warranties to hedge the risks of insurance companies, with prices changing in real time depending on liquidity. For the most part markets are generally efficient.
However, occasionally the market prices of certain securities trade inefficiently and the event driven manager seeks to exploit this. Although too many event driven managers operating in a small or illiquid market will tend to quickly remove such inefficiencies thus reducing the risk-adjusted returns.
In extreme cases, this overcrowding may push prices too far in one direction and again create a state of market inefficiency but in reverse. Astute managers are keenly aware of this. Certain event driven managers specialize in these situations and may implement trades that are the opposite of what was initially expected and take a position against the majority.
Economists may welcome market efficiency but event driven investment managers take the opposite view. That is, until they fully execute their initial trade. The investment focus of the manager is to analyse the effect on security prices due to the event in question. This is in contrast to traditional equity investment funds who focus on analysing and researching company earnings or dividend streams. Investment firms using event driven investment strategies employ teams of specialists who are experts in analysing corporate actions.
The manager then makes a decision on how to invest in the situation. This decision makes use of the available financial instruments such as stock or bonds. To illustrate, we again use a merger arbitrage example. Once an acquiring company announces its intent to buy another company, the stock price of the target company typically rises. However, it usually remains below the acquisition price.
This discount, known as the spread , reflects the uncertainty about whether the acquisition will complete or not. Event-driven managers analyze the deal particulars, which may include but are not limited to the reasons for the acquisition , the terms of the acquisition and any regulatory issues. With this information, manager determine the likelihood of the acquisition successfully completing.
If the target stock price suggests a lower likelihood of deal completion, the manager will buy the stock. The manager is comfortable buying the stock, as opposed to the traditional manager who does not have the expertise to determine if the deal will go through. The traditional manager often sells the stock before the acquisition completes and realizes a profit but sacrifices the remaining upside.
This remaining upside, or spread , is where the merger arbitrageur can profit.
Event-driven investing or Event-driven trading is a hedge fund investment strategy that seeks to exploit pricing inefficiencies that may occur before or. Event Driven Hedge Fund Proxy: investable daily liquid broadly diversified portfolio. A well-defined, repeatable investment strategy and. Event-driven funds lead hedge fund losses The analysts said these strategies have high beta, meaning they will benefit from the market.