Beta Dispersion and Market-Timing

Abstract

This paper examines the dispersion of betas, which is the spread between highest and lowest betas on a market, and its application. The beta dispersion can be interpreted as risk measure for the likelihood of market crashes and therefore function as a predictor of following market downturns. Based on the beta dispersion and the highest betas on a market, indicators are developed to predict the subsequent market return. These indicators have substantial predictive power for future market movements, even out-of-sample and if additionally controlled for other well-known predictors of the market return. Moreover, the informational content of the beta dispersion can be successfully exploited by market-timing strategies. An innovative idea of designing market-timing strategies based on timing indicators is introduced. This new approach invests in the market portfolio with a weighted position conditioning on the currently observed indicator. The market-timing strategies are able to considerably enhance the risk-return characteristics compared to a buy-and-hold investment in the market, especially by reducing the return volatility about one third.