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Friday, February 28, 2014

What is Beta of a Portfolio?

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Beta measures the relative risk of a fund or portfolio in relation to the market portfolio. In other words, it reflects the systematic risk associated with the fund. The market index has a beta of one. A beta higher than one means the fund is riskier than the benchmark and a beta less than one indicates lesser volatility than the benchmark. A beta of 1.1 implies that the fund has a volatility that is 1.1 times the benchmark volatility.

Volatility is not necessarily a bad thing. All that a beta suggests is that if the underlying stocks in an equity fund are chosen in such a way that their cumulative beta is say 1.2, if the market benchmark goes up by 10%, you should expect this fund to go up by 12% and conversely, if the market benchmark were to decline by 10%, you should expect this fund to decline by 12% : by 1.2 times the movement of the benchmark.

Beta is found out using regression and may be expressed as the covariance between the fund and the benchmark divided by the variance of the benchmark. A high beta is associated with a higher return.

In a bullish market, investors should select a fund with higher beta as likelihood of higher returns for taking higher risk are more. While in a bearish market, a fund with lower beta would be more appropriate as it is defensive against the market.

If you expect markets to be bearish, you would like to look for funds that have a low beta - which can provide you relative protection in market corrections and fall perhaps less than the market.

 

 

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