Robin Marshall, M.A., M. Phil
Mark Barnes, PhD
Indhu Raghavan, CFA
- The cyclicality of industries and sectors, as measured by their beta to the broad market, is not static, but responds to changes in the market benchmark, changes in the economic and regulatory environment, and economic shocks.
- A new paper from FTSE Russell explores the changes in beta of industries and sectors in the Russell 1000 index that are driven both by potentially transitory effects (Covid supply shock, oil price shocks) and by structural shifts in the economy (AI technologies, the green transition, the legacies of post-GFC regulation and Covid).
- Recent beta changes challenge investor assumptions of stable betas. Investors should be mindful of these shifts when thinking about the cyclical/defensive characteristics of their portfolios.
- While it is difficult to determine whether beta changes are temporary or permanent, investors should consider the persistence of economic shocks in forming expectations of beta.
Why betas matter
The cyclicality of a group of stocks, as measured by their beta to the broad market, gives us an idea of the direction and degree of their co-movement with the market. Are stocks in a certain industry more cyclical, moving in sync with the market and benefiting from broad market rallies, or are they more defensive, moving differently from the market and buffering portfolios in the event of a broad downturn? It is an important question when thinking about the risk characteristics of a portfolio.
Investors may assume that these co-movement characteristics are set in stone. However, the cyclicality of stocks is not static. This is illustrated in Exhibit 1 which shows the rolling 36-month betas to the Russell 1000 index for the Semiconductors and Conventional Electricity sub-sectors within the Technology and Utilities industries, respectively. These betas, which depend both on the sub-sector’s correlation to the benchmark and relative volatility, have risen notably since 2020. Semiconductors have gone from having slightly higher than benchmark risk, to being a high beta segment of the market. On the other hand, the Conventional Electricity sub-sector has gone from being super defensive to having risk much more in line with that of the benchmark.
Exhibit 1: Semiconductors and Conventional Electricity sub-sector 36-month rolling betas to Russell 1000
Source: FTSE Russell/LSEG. Data as of 31 July 2024. Please see the end for important legal disclosures.
What is driving these changes? We explore this and beta changes in other parts of the US market in a new Research paper entitled “US equity market betas – why they matter and how they are changing.”
The paper reviews the intuition of betas, and presents some recent examples of betas changing, with an eye to whether these changes are expected to be permanent or temporary. It focuses on recent secular trends that seem to have contributed to changing betas, including the green transition, Covid, and the artificial intelligence (AI) boom. The paper uses data from the Russell 1000 index, so the conclusions drawn are specifically about US large-cap securities. However, the intuition and the lessons learned can be applied more generally.
Semiconductors and Electricity sub-sector betas rise amid AI enthusiasm
One of the structural changes we explore in the paper is the AI boom. The potential for AI technologies to enhance productivity across the economy has led to heavy capital investment in this area. The beneficiaries of this investment are spread across the technology supply chain, including semiconductor manufacturers. Unsurprisingly, the Semiconductors sub-sector, which was already cyclical, with a beta between 1.0 and 1.2 over the last ten years, saw its beta rise sharply since end-2021 to around 1.7 as of July 2024. This rise came in the context of the Technology industry’s own growing weight in the Russell 1000 benchmark (up from 14% in January 2010 to 35% in July 2024.)
Electricity generation is another beneficiary of AI that has generated enormous demand for electricity to power data centers. As such, the Conventional Electricity sub-sector, including companies that generate and distribute electricity using fossil fuels, has become more immediately tied to the broader equity market, resulting in a higher correlation with the benchmark, and a higher beta. This sub-sector has contributed to a higher beta for the Utilities industry as a whole, challenging the traditional view of Utilities as a defensive area.
AI investment is an example of a secular shift in the economy that will likely take place over a period of time. However, there are other shocks to the market that propelled rapid change in the industry beta and could be less stable.
The case of Energy—transitory shocks and changes in beta?
The Energy industry is another good example of dramatic changes in beta arising from economic shocks that significantly changed its correlation to the benchmark. Exhibit 2 shows that the industry’s 36-month rolling beta to the Russell 1000 benchmark has gone through massive swings.
Exhibit 2: Energy industry 36-month rolling beta to Russell 1000
Source: FTSE Russell/LSEG. Data as of 31 July 2024. Please see the end for important legal disclosures.
Energy’s beta spiked in March 2020 at the beginning of the Covid shock as the market sold off and correlations rose. However, while the broader equity market bounced back relatively quickly, the global economic slowdown led to a prolonged slump in oil prices, and in the Energy industry. Oil prices did rebound with the invasion of Ukraine in early 2022, at the same time that rising interest rates led to a broad sell-off in the market. Once again, this led to a disconnect between Energy and the rest of the market. Between the Covid and Ukraine shocks, the correlation between Energy and the Russell 1000 benchmark dropped, leading to a low beta recently. However, it is doubtful this low correlation will persist, and we might expect that Energy’s beta return to its long-time trend.
In addition to the transitions and shocks described above, the paper explores beta changes related to the themes of the green transition, the lasting impact of post-GFC financial regulation, and the legacies of Covid era practices on the real estate industry. In doing so, the paper presents cyclicality as a dynamic concept and beta as a portfolio characteristic that merits continuous monitoring.
Conclusion
The cyclicality of industries and sectors is an important question when thinking about the risk characteristics of a portfolio. Our analysis of recent Russell 1000 data shows that betas are not static but respond to changes in the benchmark, changes in the economic and regulatory environment, and economic shocks.
Whether these changes in beta prove permanent will depend on the persistence of the shocks and investment behavior in response to those shocks. But the data suggests it is important investors continually monitor and update their views and expectations of betas and the risk characteristics of their portfolios.
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