Quant Logic Tackles Sloppy Betas in Finance. (Part I)

I’ve been blogging a lot recently to the lay investing community.  I feel it is time to geek out a bit and exercise my inner quant (Quantitative analyst).  I was in the shower thinking about beta and expected return.  My mind came back to something that has bothered me for years… that beta is not rigorously defined.  It occurred to me, strikingly, that if beta is poorly defined then so is alpha!

Now this is somewhat unsettling since CAPM is highly wedded to the concept of beta, and alpha [which some scholars believe is approximately 0].  Let me be clear, the sampling frequency and sampling period of beta are not consistently defined!  One common definition of beta is based on monthly sampling over a period of one year.  Another definition I’ve seen is monthly sampling over a three year period.  I’ve also seen daily (trading days) sampling over periods of about 1-3 years.  Investments 6th Edition (Bodie, Kane, and Marcus)  even mentions the Merrill Lynch concept of adjusted beta (= 2/3 sample beta + 1/3).

These fast and loose definitions of beta are in sharp [no pun intended] contrast to the more rigorous definitions of maturity, duration, coupon rate, yield to maturity, etc. in the study of bonds.

The net effect of “beta sloppiness” is that a given given security, on the same day can get different betas from different investing houses even though they are all using the same data!  To put it mildly, I think this is kind of a big deal.   Beta, alpha, efficient frontiers, “risk free assets”, and CAPM are all interesting and useful concepts.   I think that after 50+ years, it is finally time to put a bit more rigor into the fundamental building blocks of modern portfolio theory.  I plan to crunch a few numbers and refine and test a few ideas, and I intent to help start doing just that (or at least help encourage others to) in the weeks ahead.

Creative Finance

The last few weeks have been busy for Balhiser LLC. First the small biz was denied a $50,000 line of credit from a bank despite an excellent credit credit score, collateral and cash flow. That’s where creative financing come into play. It occurred to me, as president of Balhiser LLC, that the real estate venture was a good investment, and the the bank had made an error by rejecting the application on the basis of “industry: real estate”. I came up with the idea of a risk-sharing loan that would pay the lender a percentage of gross revenue from the income property in proportion to the loan-to-value of the property. The “angel” lender turned out to be a non-bank individual. The terms of the gross revenue agreement include a minimum 6-month term at which point the loan becomes callable and repayable in full or in part.

The lender gets a good deal because they realize proportional gross revenue. Balhiser LLC gets a good deal because it receives financing to close the capitalization gap with a non-bank lender sharing the revenue risk. The classic win-win business deal. So long as the property goes unrented no “interest” is due.

As it turns out, a 12-month lease on the property was signed on January 27th. If all goes according to plan both my small biz and the private lender will do reasonably well. The lender stands to receive just over 8% return.

Real Estate Diversification

Balhiser LLC is entering the real estate investing world. As president, I am working on the last steps of financing a payoff and transfer of a ~$175,000 property to Balhiser LLC. So far, I have secured 65% of the capital and financing. Financing the remaining 35% is in the works, and I am hopeful that a line of credit Balhiser LLC has applied for will help close the gap. Alternately, I am prepared to liquidate some of my Vanguard portfolio, as required to complete the transfer.

The goal is to lease the property, a 3 bedroom townhouse, for $1150/mo. Info about the property is available here.

Investing can be more than just stocks, bonds, ETFs, and options. It is exciting to extend Balhiser LLC into the arena of real estate investment.