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I have a portfolio which seems to have outperformed the benchmark for the past 2 years however the risk system I use advises that using recent past data (lookback period of 2 years) the Beta to this benchmark is less than 1. I find this counter intuitive, how is this possible?

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  • $\begingroup$ Via your logic is sounds like the only way to outperform the market is to use leverage on a market portfolio and get its beta above 1. Does that sounds plausible to you? $\endgroup$ – roz Feb 27 '20 at 15:40
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    $\begingroup$ You could hold cash in a period where the market goes down... $\endgroup$ – Chris Taylor Feb 27 '20 at 18:41
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Just to be entirely clear, when you say Beta, you really mean that you estimate a CAPM-style time series equation of the sort: \begin{equation} R_t(portfolio) - r_f = \alpha + \beta*(R_t(benchmark) - r_f) + \epsilon_t \end{equation} by OLS, right? If so, you can get an estimate below unity and still outperform the becnhmark. If you capitalized on either pricing mistakes or risk exposures that aren't found in the benchmark portfolio, you would get higher returns on average.

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It is possible to outperform the market with a beta lower than 1.

Imagine a portfolio that has a beta = 0.5 and is only exposed to systematic risk (no idiosyncratic risk), then the following three statements are true.

If the market prices are uniformly decreasing, then a portfolio with a beta < 1 will always outperform the market.

If the market prices are uniformly increasing, then a portfolio with a beta < 1 will never outperform the market.

If market prices are not uniformly increasing or decreasing, then it is not immediately clear how a portfolio with a beta < 1 will perform in comparison to the market.

In a realistic scenario the portfolio will also be exposed to idiosyncratic risk, and then the words "always" and "never" must be replaced with "tends to".

So to sum this up, it all depends on the market performance, but basically in a bear market a portfolio with a beta < 1 should outperform the market because the portfolio losses will be lower than the market losses.

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