What is Zero-Beta Portfolio?

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A zero-beta portfolio is a portfolio constructed to have zero systematic risk, or in other words, a beta of zero. A zero-beta portfolio would have the same expected return as the risk-free rate. Such a portfolio would have zero correlation with market movements, given that its expected return equals the risk-free rate or a relatively low rate of return compared to higher-beta portfolios.A zero-beta portfolio is quite unlikely to attract investor interest in bull markets, since such a portfolio has no market exposure and would therefore underperform a diversified market portfolio. It may attract some interest during a bear market, but investors are likely to question whether merely investing in risk-free, short-term treasuries is a better and cheaper alternative to a zero-cost portfolio.

Definition

A zero beta portfolio is constructed to have zero systematic risk, meaning its beta value is zero. The expected return of a zero beta portfolio is the same as the risk-free rate. This type of portfolio is completely uncorrelated with market fluctuations, as its expected return equals the risk-free rate or is lower compared to high beta portfolios.

Origin

The concept of a zero beta portfolio originates from the Capital Asset Pricing Model (CAPM), introduced by William Sharpe in the 1960s. The CAPM model uses the beta coefficient to measure an asset's systematic risk, and the zero beta portfolio is a special application of this model aimed at eliminating market risk.

Categories and Features

The main feature of a zero beta portfolio is its zero beta value, indicating it is unaffected by market volatility. Its expected return is equivalent to the risk-free rate, typically achieved by investing in short-term government bonds or other risk-free assets. While it underperforms in bull markets, it may offer stable returns during bear markets.

Case Studies

Case Study 1: During the 2008 financial crisis, some investors opted for zero beta portfolios to avoid market risk. These investors successfully avoided market volatility by investing in short-term government bonds and other low-risk assets. Case Study 2: In the early stages of the 2020 pandemic, with markets highly volatile, some conservative investors turned to zero beta portfolios to protect their assets, despite missing out on potential market rebound gains.

Common Issues

Common issues include whether a zero beta portfolio is always superior to a market portfolio. The answer is no, as during market upswings, a zero beta portfolio's returns may be lower than the market average. Additionally, investors might question its cost-effectiveness, especially when direct investment in risk-free assets is possible.

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