Beta Dispersion and Market-Timing

Abstract

This paper examines the dispersion of betas, which is the spread of betas on a market, and its application as market return predictor. The beta dispersion can be interpreted as a measure of risk for market crashes and therefore function as a predictor of the following market downturns. Based on the beta dispersion, indicators are developed to predict the future market return. These dispersion measures have substantial predictive power for future market movements, even out-of-sample and after controlling for other well-known predictors of the market return. Moreover, I show that 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 riskreturn characteristics compared to a buy-and-hold investment in the market and a common 60/40 portfolio split, especially by reducing the return volatility.

Keywords: systematic risk, time-varying beta, market return predictability, market-timing, investment strategies

JEL Classification: G10, G11, G17