ETFs and Risk Measurement: Beta Assesses Price Swings Relative to Market - dummies

ETFs and Risk Measurement: Beta Assesses Price Swings Relative to Market

By Russell Wild

Beta is a relative measure of volatility for your ETF investment. It is used to measure the volatility of something in relation to something else. Most commonly that “something else” is the S&P 500. Very simply, beta tells you that if the S&P rises or falls by x percent, then our investment, whatever that investment is, will likely rise or fall by y percent.

The S&P is considered our baseline, and it is assigned a beta of 1. So if you know that Humongous Software Corporation has a beta of 2, and the S&P shoots up 10 percent, Jimmy the Greek (if he were still with us) would bet that shares of Humongous are going to rise 20 percent.

If you know that the Sedate Utility Company has a beta of 0.5, and the S&P shoots up 10 percent, Jimmy would bet that shares of Sedate are going to rise by 5 percent. Conversely, shares of Humongous would likely fall four times harder than shares of Sedate in response to a fall in the S&P.

In a way, beta is easier to understand than standard deviation; it’s also easier to misinterpret. Beta’s usefulness is greater for individual stocks than it is for ETFs, but nonetheless it can be helpful, especially when gauging the volatility of U.S. industry-sector ETFs. It is much less useful for any ETF that has international holdings.

For example, an ETF that holds stocks of emerging-market nations is going to be volatile, yet it may have a low beta. How so? Because its movements, no matter how swooping, don’t generally happen in response to movement in the U.S. market. (Emerging-market stocks tend to be more tied to currency flux, commodity prices, interest rates, and political climate.)

Following are the (three-year) standard deviations and betas of several diverse ETFs. Note that iShares MSCI Hong Kong (EWH) is more volatile than iShares MSCI U.K. Index (EWU) as measured by its standard deviation, but EWH has a lower beta.

That tells you that the volatility of the Hong Kong market, however great it is, seems to be less tied to the fortunes of the S&P 500 than is the volatility of the U.K. market.

ETF Ticker Standard Deviation Beta
SPDR S&P 500 SPY 21.8 1.0
Consumer Staples Select Sector SPDR XLP 14.7 0.59
Health Care Select Sector SPDR XLV 17.6 0.66
iShares MSCI U.K. Index EWU 27.1 1.11
PowerShares QQQ Trust Series 1 QQQ 25.1 1.07
iShares MSCI Hong Kong EWH 28.3 0.55