Beta

This common measure compares a mutual fund's volatility with that of a benchmark and is supposed to give some sense of how far investor can expect a fund to fall when the market takes a dive, or how high it might climb if the bull is running hard. A fund with a beta greater than 1 is considered more volatile than the market; less than 1 means less volatile. So say Investor’s fund gets a beta of 1.15. it has a history of fluctuating 15% more than the benchmark If the market is up, the fund should outperform by 15%. If the market heads lower, the fund should fall by 15% more.

But beta, though a useful guide, is far from perfect, especially when used as a proxy for "risk." The problem here, as with many risk measures, is the benchmark. The benchmark has to be a correct measure of comparison only then will the beta hold any indicative value.

Beta is a statistical measure that shows how sensitive a fund is to market moves. If the Sensex moves by 25 per cent, a fund's beta number will tell investor whether the fund's returns will be more than this or less. The beta value for an index itself is taken as one. Equity funds can have beta values, which can be above one, less than one or equal to one. By multiplying the beta value of a fund with the expected percentage movement of an index, the expected movement in the fund can be determined. Thus if a fund has a beta of 1.2 and the market is expected to move up by ten per cent, the fund should move by 12 per cent (obtained as 1.2 multiplied by 10). Similarly,  if the market loses ten per cent, the fund should lose 12 per cent.

Each dot represents a fund's returns plotted against the market returns in the same period. The line is the beta of these returns. While the beta is same in both, it is far more representative of the returns in the left graph then right one. This shows that a fund with a beta of more than one will rise more than the market and also fall more than market. Clearly, if you would like to beat the market on the upside, it is best to invest in a high-beta fund. But you must keep in mind that such a fund will also fall more than the market on the way down. Similarly, a low-beta fund will rise less than the market on the way up and lose less on the way down. When safety of investment is important, a fund with a beta of less than one is a better option. Such a fund may not gain much more than the market on the upside; it will protect returns better when market falls.

Essentially, beta expresses the fundamental trade-off between minimizing risk and maximizing return. A fund with a beta of 1 will historically move in the same direction of the market. A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile. So while you can expect a high return from a fund that has a beta of 2, you will have to expect it to drop much more when the market falls. The effectiveness of the beta depends on the index used to calculate it. It can happen that the index bears no correlation with the movements in the fund.