Beta Management Company

HBS case no. 9-292-122

Case details
1) Jan 1991 - BMC had $25 mn.AUM.
2) BMC's satted goals were to enhance returns but reduce risks for clients via market timing.
3) BMC kept a majority of funds in no-load low-expense index funds with the balance in money market instruments.
BMC used Vanguard's Index 500 Trust due to its extremely low expense ratio and its success at closely matching the retu
4) As of Jan 4, 1991 BMC had 79.2% of $25 mn invested in Vanguard fund.
5) New year resolution was to look for some individual stocks for possible purchase for MC's equity portfolio. Focus was o
proportion of equities as the market was still a good value.
6) BMC considering two NYSE-listed companies, California REIT and Brown Group since their prices seemed unreasonabl
7) california REIT was an extremely volatile stock and price was $2.25 as on Jan 4, 1991.
8) Brown Group stock price seemed quite variable and price was $24 as on Jan 4, 1991.

Exhibits
1) Investment return data
2) Monthly returns of California REIT vs S&P 500 Index Fund
3) Monthly returns of Brown Group Inc. vs S&P 500 Index Fund

Case questions
1) Calculate the standard deviation of stock returns of California REIT and Brown Group during the past 2 years.
How variable are they compared with Vanguard Index 500 Trust? Which stock appears to be riskiest?
2) Suppose Beta's position had been 99% of equity funds invested in the Index fund and 1% in the individual stock. Calcu
using each stock. How does each stock affect the variability of the equity investment, and which stock is riskiest?
Explain how this makes sense in view of your answer to Q1 above.
3) Perform a regression of each stocl's monthly returns on the index returns to compute the beta for each stock.
How does this relate to the situation described in Q2 above?
4) How might the expected return for each stock relate to its riskiness?
y market instruments.
closely matching the return on the S&P 500 Index.

quity portfolio. Focus was on smaller stocks. Also to increase

rices seemed unreasonably low.

the past 2 years.

the individual stock. Calculate the variability of the portfolio

h stock is riskiest?

eta for each stock.

 ANALYSIS
Monthly Returns Portfolio Returns
Month California REIT Brown Group Vanguard Index 99% VG + 1% Cal REIT
1989 - January -28.26% 9.16% 7.32% 6.96%
Februar -3.03% 0.73% -2.47% -2.48%
yMarch 8.75% -0.29% 2.26% 2.32%
April -1.47% 2.21% 5.18% 5.11%
May -1.49% -1.08% 4.04% 3.98%
June -9.09% -0.65% -0.59% -0.68%
July 10.67% 2.22% 9.01% 9.03%
August -9.38% 0.00% 1.86% 1.75%
Septem 10.34% 1.88% -0.40% -0.29%
ber
October -14.38% -7.55% -2.34% -2.46%
Novem -14.81% -12.84% 2.04% 1.87%
ber
Decem -4.35% -1.70% 2.38% 2.31%
ber
1990 - January -5.45% -15.21% -6.72% -6.71%
Februar 5.00% 7.61% 1.27% 1.31%
yMarch 9.52% 1.11% 2.61% 2.68%
April -0.87% -0.51% -2.50% -2.48%
May 0.00% 12.71% 9.69% 9.59%
June 4.55% 3.32% -0.69% -0.64%
July 3.48% 3.17% -0.32% -0.28%
August 0.00% -14.72% -9.03% -8.94%
Septem -13.04% -1.91% -4.89% -4.97%
ber
October 0.00% -12.50% -0.41% -0.41%
Novem 1.50% 17.26% 6.44% 6.39%
ber
Decem -2.56% -8.53% 2.72% 2.67%
ber
Std. 9.231% 8.167% 4.606% 4.568%
Dev.
Correl with VG 0.074 0.656
Beta 0.147 1.163
Intercept -0.024 -0.020

Relationship CAL REIT = -0.024+0.147*VG Index Brown = -0.020+1.163*VG Index

R Square 0.005 0.431

Q1 Calculate the standard deviation of stock returns of California REIT and Brown Group during the past 2 years.
How variable are they compared with Vanguard Index 500 Trust? Which stock appears to be riskiest?
The figures are as shown above. CAL REIT is riskiest.

Q2 Suppose Beta's position had been 99% of equity funds invested in the Index fund and 1% in the individual stock. Calcu
using each stock. How does each stock affect the variability of the equity investment, and which stock is riskiest?
Explain how this makes sense in view of your answer to Q1 above.
The portfolio total risk figures are as shown above.
Portfolio risk reduces with CAL REIT but increases with Brown vis-à-vis 100% VG index due higher correlation with BG. BG
Q3 Perform a regression of each stock's monthly returns on the index returns to compute the beta for each stock.
How does this relate to the situation described in Q2 above?
Beta figures are as shown above.

California REIT Brown

Total risk (sd) 9.23% 8.17%
Sys risk (sd) 0.68% 5.36% �_𝑖𝑡^2=𝛽_𝑖𝑡^2
Unsys risk (sd) 9.21% 6.16% �_𝑚𝑡^2+�_𝑒𝑖𝑡^2

Q4 How might the expected return for each stock relate to its riskiness?
CAL REIT return is on account of low sys risk but high unsys risk.
BG return is on account of near equal amounts of sys and unsys risks.
 99% VG + 1% BG
7.34%
-2.44%
2.23%
5.15%
3.99%
-0.59%
8.94%
1.84%
-0.38%
-2.39%
1.89%
2.34%
-6.80%
1.33%
2.60%
-2.48%
9.72%
-0.65%
-0.29%
-9.09%
-4.86%
-0.53%
6.55%
2.61%

4.614%

ng the past 2 years.

n the individual stock. Calculate the variability of the portfolio

which stock is riskiest?

igher correlation with BG. BG now appears riskier.

beta for each stock.
Solution 2: Calculation of Portfolio Risk

Portfolio 1: 99% Index + 1% California REIT

Weight 0.99 0.01

Vanguard Index California
MONTH 500 Trust REIT Portfolio
1989 - January 7.32% -28.26% 6.96%
February -2.47% -3.03% -2.48%
March 2.26% 8.75% 2.32%
April 5.18% -1.47% 5.11%
May 4.04% -1.49% 3.98%
June -0.59% -9.09% -0.68%
July 9.01% 10.67% 9.03%
August 1.86% -9.38% 1.75%
September -0.40% 10.34% -0.29%
October -2.34% -14.38% -2.46%
November 2.04% -14.81% 1.87%
December 2.38% -4.35% 2.31%
1990 - January -6.72% -5.45% -6.71%
February 1.27% 5.00% 1.31%
March 2.61% 9.52% 2.68%
April -2.50% -0.87% -2.48%
May 9.69% 0.00% 9.59%
June -0.69% 4.55% -0.64%
July -0.32% 3.48% -0.28%
August -9.03% 0.00% -8.94%
September -4.89% -13.04% -4.97%
October -0.41% 0.00% -0.41%
November 6.44% 1.50% 6.39%
December 2.72% -2.56% 2.67%

Standard Deviation 4.606% 9.231% 4.568%

Variance 0.0021 0.0085 0.0021
Covariance 0.0003
m m
Alternatively,
p   x x 
j 1 k 1
j k jk

Portfolio Standard
4.568%
Deviation

Change in Variability / Risk

Sarah's Initial Invetsment: 99% in Vanguard Index 500
Risk Before the Investment = 4.560% (99% of sd)
Risk After the additional 1% Investment in following securities:
1% Investment in Portfolio σ Old σ Change in σ
California REIT 4.568% 4.560% 0.008%
Brown Group 4.614% 4.560% 0.054%
Vanguard Index 500 4.606% 4.560% 0.046%
Portfolio 2: 99% Index + 1% Brown Group

Weight 0.99 0.01

Vanguard Index
MONTH 500 Trust Brown Group Portfolio
1989 - January 7.32% 9.16% 7.34%
February -2.47% 0.73% -2.44%
March 2.26% -0.29% 2.23%
April 5.18% 2.21% 5.15%
May 4.04% -1.08% 3.99%
June -0.59% -0.65% -0.59%
July 9.01% 2.22% 8.94%
August 1.86% 0.00% 1.84%
September -0.40% 1.88% -0.38%
October -2.34% -7.55% -2.39%
November 2.04% -12.84% 1.89%
December 2.38% -1.70% 2.34%
1990 - January -6.72% -15.21% -6.80%
February 1.27% 7.61% 1.33%
March 2.61% 1.11% 2.60%
April -2.50% -0.51% -2.48%
May 9.69% 12.71% 9.72%
June -0.69% 3.32% -0.65%
July -0.32% 3.17% -0.29%
August -9.03% -14.72% -9.09%
September -4.89% -1.91% -4.86%
October -0.41% -12.50% -0.53%
November 6.44% 17.26% 6.55%
December 2.72% -8.53% 2.61%

Standard Deviation 4.606% 8.167% 4.614%

Variance 0.0021 0.0067 0.0021
Covariance 0.002

Portfolio Standard
4.614%
Deviation
Solution 3 - Calculation of β

Vanguard Index California Brown

MONTH 500 Trust REIT Group
1989 - January 7.32% -28.26% 9.16%
February -2.47% -3.03% 0.73%
March 2.26% 8.75% -0.29%
April 5.18% -1.47% 2.21%
May 4.04% -1.49% -1.08%
June -0.59% -9.09% -0.65%
July 9.01% 10.67% 2.22%
August 1.86% -9.38% 0.00%
Septemb -0.40% 10.34% 1.88%
er
October -2.34% -14.38% -7.55%
Novemb 2.04% -14.81% -12.84%
er
Decemb 2.38% -4.35% -1.70%
er
1990 - January -6.72% -5.45% -15.21%
February 1.27% 5.00% 7.61%
March 2.61% 9.52% 1.11%
April -2.50% -0.87% -0.51%
May 9.69% 0.00% 12.71%
June -0.69% 4.55% 3.32%
July -0.32% 3.48% 3.17%
August -9.03% 0.00% -14.72%
Septemb -4.89% -13.04% -1.91%
er
October -0.41% 0.00% -12.50%
Novemb 6.44% 1.50% 17.26%
er
Decemb 2.72% -2.56% -8.53%
er
β 1 0.15 1.16

Regression of California REIT Returns on Market Index Returns (Vanguard Index 500 Trust)

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.0735316602
R Square 0.005406905
Adjusted R Square -0.039801872
Standard Error 0.0941264386
Observations 24

ANOVA
df SS MS F Significance F
Regression 1 0.001059618 0.001059618 0.1195986 0.7327555022
Residual 22 0.194915302 0.008859786
Total 23 0.19597492

Standard Upper
Coefficients t Stat P-value Lower 95%
Error 95%
Intercept -0.0242787162 0.019779398 -1.22747496 0.232617 -0.0652986777 0.0167412
Vanguard Index 0.1473514325 0.426080217 0.345830261 0.7327555 -0.7362848548 1.0309877
500 Trust
RESIDUAL OUTPUT

Predicted
Observation Residuals
California REIT Scatter Plot and Regression Line of
1 -0.0134925913 -0.26910741

California REIT Returns

2 -0.0279182966 -0.0023817 20.00%
3 -0.0209485738 0.108448574
4 -0.016645912 0.001945912 15.00%
5 -0.0183257183 0.003425718
6 -0.0251480897 -0.06575191 10.00%
7 -0.0110023521 0.117702352
8 -0.0215379796 -0.07226202 5.00%
9 -0.0248681219 0.128268122
10 -0.0277267397 -0.11607326 0.00%
-10.00% -8.00% -6.00% -4.00% -2.00% 0.00% 2.00%
11 -0.021272747 -0.12682725
-5.00%
12 -0.0207717521 -0.02272825
13 -0.0341807325 -0.02031927
-10.00%
14 -0.022407353 0.072407353
15 -0.0204328438 0.115632844
-15.00%
16 -0.027962502 0.019262502
17 -0.0100003624 0.010000362
-20.00%
18 -0.0252954411 0.070795441
19 -0.0247502408 0.059550241
-25.00%
20 -0.0375845506 0.037584551
21 -0.0314842013 -0.0989158 -30.00%
22 -0.0248828571 0.024882857
23 -0.014789284 0.029789284 Vanguard Index 500 Trust Ret
24 -0.0202707572 -0.00532924

Regression of Brown Group Returns on Market Index (Vanguard Index 500 Trust) Returns

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.6561697663
R Square 0.4305587622
Adjusted R Square 0.4046750696
Standard Error 0.0630126029
Observations 24

ANOVA
df SS MS F Significance F
Regression 1 0.066048208 0.066048208 16.634364 0.0004980217
Residual 22 0.087352939 0.003970588
Total 23 0.153401146

Standard Upper
Coefficients t Stat P-value Lower 95%
Error 95%
Intercept -0.0195384298 0.013241246 -1.47557331 0.1542282 -0.0469990942 0.0079222
Vanguard Index
1.1633496457 0.285237856 4.078524721 0.000498 0.5718025389 1.7548968
500 Trust

RESIDUAL OUTPUT

Predicted Brown
Observation Residuals
Group Scatter Plot and Regression Line
1 0.0656187642 0.025981236
20.00%

Brown Group Returns

2 -0.0482731661 0.055573166
3 0.0067532721 -0.00965327
4 0.0407230818 -0.01862308 15.00%
5 0.0274608958 -0.0382609
6 -0.0264021928 0.019902193 10.00%
7 0.0852793732 -0.06307937
8 0.0020998736 -0.00209987 5.00%
9 -0.0241918284 0.042991828
10 -0.0467608116 -0.02873919 0.00%
-10.00% -8.00% -6.00% -4.00% -2.00% 0.00% 2.
11 0.0041939029 -0.1325939
-5.00%
12 0.0081492917 -0.02514929
13 -0.097715526 -0.05438447
-10.00%
14 -0.0047638893 0.080863889
15 0.0108249959 0.000275004
-15.00%
16 -0.048622171 0.043522171
17 0.0931901508 0.033909849 -20.00%
18 -0.0275655424 0.060765542
19 -0.0232611487 0.054961149 -25.00%
20 -0.1245889029 -0.0226111
21 -0.0764262275 0.057326228 -30.00%
22 -0.0243081634 -0.10069184
23 0.0553812873 0.117218713 Vanguard Index 500 Trust
24 0.0121046805 -0.09740468
 Lower Upper
95.0% 95.0%
-0.065299 0.0167412

-0.736285 1.0309877
t and Regression Line of Cal REIT Returns Vs. Market Index Returns
20.00%

15.00%

10.00%

5.00%

0.00%
-4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% California REIT
-5.00% Predicted California REIT
Linear (Predicted California REIT)
-10.00%

-15.00%

-20.00%

-25.00%

-30.00%

Vanguard Index 500 Trust Returns

Lower Upper
95.0% 95.0%
 -0.046999 0.0079222

0.5718025 1.7548968

Plot and Regression Line of Brown Group Returns Vs. Index Returns
20.00%

15.00%

10.00%

5.00%

0.00%
% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% Brown Group
-5.00% Predicted Brown Group
Linear (Predicted Brown Group)
-10.00%

-15.00%

-20.00%

-25.00%

-30.00%

Vanguard Index 500 Trust Returns

Solution 4 - Developing the Risk-Return Relationship Using σ Risk Measures

From solution to question 2, it follows:

California REIT Risk-Return Relationship Brown Group Risk-Return Relationship

(𝑅_𝐶 − 𝑅_𝐹)/.008= (𝑅_𝑀 − (𝑅_𝐵 − 𝑅_𝐹)/.054= (𝑅_𝑀 −

𝑅_𝐹)/.046 𝑅_𝐹)/.046

𝑅_𝐶= 𝑅_𝐹+ .008/.046 (𝑅_𝑀 − 𝑅_𝐵= 𝑅_𝐹+ .054/.046 (𝑅_𝑀 −

𝑅_𝐹) 𝑅_𝐹)

𝑅_𝐶= 𝑅_𝐹+ .𝟏𝟕 (𝑅_𝑀 − 𝑅_𝐹) 𝑅_𝐵= 𝑅_𝐹+𝟏.𝟏𝟕 (𝑅_𝑀 − 𝑅_𝐹)

This nearly equals the regression This nearly equals the regression
beta (0.15) for California REIT beta (1.16) for Brown Group
computed in solution to problem 3 computed in solution to problem 3
Change in Variability / Risk
Sarah's Initial Invetsment: 99% in Vanguard Index 500
Risk Before the Investment = 4.560%
Risk After the additional 1% Investment in following securities:

1% Investment in Portfolio σ Old σ Change in σ

California REIT 4.568% 4.560% 0.008%
Brown Group 4.614% 4.560% 0.054%
Vanguard Index 500 4.606% 4.560% 0.046%