Beta-Adjusted

Net exposure by itself is insufficient to analyze a portfolio’s risk because it neglects the different sensitivity of each position to market changes. A portfolio may consist of positions with a strong sensitivity to market changes (i.e., high-beta securities) whose weight in the portfolio is incomparable to the weight of more defensive securities (i.e., low-beta securities). Hence, introducing a more precise indicator of portfolio sensitivity to market moves is necessary.

Remember, beta measures the sensitivity of an individual stock's returns against a benchmark, typically an index like S&P500. For example, a stock with a beta of 1.5 is expected to move 1.5 times more than the benchmark. A stock with a beta of 0.8 is expected to move 0.8 times less than the benchmark.

Net exposure may be equal to zero, but the beta-adjusted exposure might not Net exposure is a static measure, while the beta-adjusted net exposure indicates the net market exposure considering the sensitivity of each portfolio position to the reference equity market.

For example, consider a fund with $80M long exposure and $40M short exposure (in the first image above). The net exposure of the fund is 80 − 40 = +40. If instead the beta of the long position is 0.5 and the beta of the short position is 1.5, the beta-adjusted net exposure equal to 80 * (0.5) − 40 * (1.5) = –20. Having a net exposure is equal to +40 and a beta-adjusted exposure of −20 is surprising.

Adjusting to beta is the key to hedging out market risk using L/S, especially within a sector. A neutral portfolio according to the beta-adjusted net exposure may not be neutral regarding sectors. Hence, the need exists to monitor the beta adjusted net exposure of each single sector comprising the portfolio.