What is Systematic Risk?

Systematic risk refers to the investment risk present in the entire market, as a function of macroeconomic, geopolitical, or policy factors. In other words, risk that is always present in public markets, but not specific to individual assets. Systematic risk may be used interchangeably with “market risk,” “undiversifiable risk,” or “volatility.”

Key Takeaways

  • Most investors with mature portfolios seek a mix of alpha and beta.
  • Private-market alternatives (like real estate) generally bear a lower degree of systematic risk.
  • REITs tend to offer a higher degree of correlation to public markets and less exposure to alpha than private real estate investments.

Unpredictability is a key feature of systematic risk; as we have noted elsewhere, “timing the market” is next to impossible, and not a viable long-term strategy. Diversification and sound asset allocation strategy are key to mitigating exposure to systematic risk.

Investing in Alpha vs Beta

“Beta” is a coefficient that reflects the volatility, or systematic risk, of an individual asset – such as a publicly-traded tech stock. A value of 1.0 indicates that the asset is strongly correlated with the overall market, and can be expected to exhibit volatility very similar to the stock market, as a whole, over time.

gradually increasing systematic risk in public markets

A beta value of greater than 1.0 indicates that the asset is more volatile than the market as a whole; adding a stock with a beta of 1.3 will theoretically increase both the risk and potential return of a portfolio. Put differently, the higher the beta value, the greater an asset’s sensitivity to systematic risk.

A beta value of less than 1.0 implies that the security is less volatile than the market as a whole, and adding the asset to a portfolio will reduce overall exposure to risk. Investing literature often refers to “investing in beta” or “buying the market” as a good way for less experienced (or time-constrained) investors to tap into broad-based growth in the economy and avoid undue volatility. As such, index funds – and a growing crop of robo-advisors who aggregate ETFs – seek to offer an aggregate beta of close to 1.0. As we have argued, investors are best served by supplementing publicly-traded assets with illiquid, private-market investments like commercial real estate.

Alpha, conversely, measures the degree to which an asset or investing strategy beats the market. The term is often used interchangeably with “abnormal rate of return”, implying that alpha can only be found via skilled management that achieves returns in excess of benchmarks. Recent data suggests that active managers of portfolios and funds are rarely able to achieve alpha consistently over the long term, prompting many investors – even those with considerable net worth – to instead allocate primarily to index funds through robo-advisors, prioritizing beta in their portfolios.

While alpha and beta are most commonly used in assessing the performance of publicly-traded stocks, these concepts are extensible to real estate investing as well. As we have noted previously, REITs tend to correlate more closely with public equities markets than illiquid, private real estate. Put differently, public REITs tend to exhibit a beta value closer to 1.0. Returns for private, illiquid real estate depend on skill in asset management and discovering value that stems from market inefficiencies: entering into a market or submarket that is undervalued; acquiring a property at below-market value; leveraging superior scale and operational capability to update multi-unit properties and bring rents to market rate; introducing new amenities or technology; or some combination thereof.

systematic risk: traditional v alternative

Meanwhile, values of private real estate assets tend to be less responsive to market shocks (particularly in certain real estate asset classes, like self-storage or workforce housing). In other words, private-market real estate carries a greater potential for achieving alpha, and entails a lower degree of systematic risk than is generally observed in public asset markets.

Private-Market Alternatives and Systematic Risk

Public markets can be roiled by macroeconomic shocks, geopolitical events, shifts in monetary policy, and other expansive forces that can abruptly and significantly shift investor perceptions. Sell-offs or exuberance can rapidly move the price of publicly-traded assets that are not directly implicated in these shifts. This dynamic helps explain the volatility of public markets which has increased over the past two decades alongside the global velocity of information. In one week in December 2018 alone, the Dow fell by 350 points or more six times[1].

Source: CNN

In the past several quarters, public markets have dipped precipitously in response to the following macro factors:

  • Interest rate hikes, and fear of subsequent interest rate hikes
  • Escalating international trade tensions
  • Subpar earnings reports from large tech companies

These events were manifestations of systematic risk, and adversely impacted the share price of public assets across sectors. Valuations of private-market alternatives, such as real estate, are illiquid and typically are not as sensitive to such macro factors. This partly reflects the tangibility and inherent worth of real estate; while a sustained economic downturn will impact average rents and real estate valuations, in the short term people will still need places to live, work, and congregate, regardless of how quickly or significantly public equities markets have plummeted.

While it is not possible to fully diversify against risk of an economic downturn, it is possible to reduce exposure to systematic risk by adding private-market alternative assets to a portfolio comprised of traditional assets like stocks and bonds.

The Bottom Line

The U.S. economy moves cyclically. While market cycles have followed some predictable patterns when examined retroactively, no human (or even machine) has been able to accurately and consistently predict major shifts in public equities markets. Broad exposure to the market – investing in beta – has proven to be a sound strategy in the long run. Exposure to illiquid, private-market alternatives – such as commercial real estate – may help to reduce an investor’s exposure to systematic risk in an era when public markets have exhibited greater volatility.

Postscript: Systematic Risk & COVID-19

Finance and investing media has referred to the advent of COVID-19 as a “black swan event” – a shock to markets that could not have been predicated or adequately priced in as risk. Whether or not an infectious disease outbreak of this magnitude could have been predicted is a matter of some debate, but it undeniably shocked financial markets. Recent surveys of economists indicated that geopolitical volatility – and its impact on foreign trade – would be a much more likely culprit for causing a recession than a pandemic.

The fallout from COVID-19 has already had profound impacts on public markets and private assets. We do not know the depth or particulars of the ensuing recession, much less the shape of the recovery. It seems likely that public health crises will be a more immediate concern for markets and investors going forward, potentially heightening public market volatility and increasing systematic risk across a wide spectrum of public assets.

[1] https://www.cnn.com/2018/12/31/investing/dow-stock-market-today/index.html

EquityMultiple's team features real estate industry veterans, technology-driven analysts, and dedicated armchair economists.
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