Beta in Mutual Funds

What is Beta in Mutual Funds?

Beta in mutual funds measures how much a fund’s returns change relative to its benchmark index, such as the Nifty 50 in India or the S&P 500 for global funds. It allows investors to evaluate how sensitive a fund is to market movements. High-Beta funds may offer higher returns during market rallies but can also face sharper declines, while low-Beta funds provide more stability with lower risk exposure.

Types of Beta in Mutual Funds

Below are the key types of Beta values and what each signifies about a mutual fund’s risk and performance behaviour:

• Positive Beta: A positive Beta shows that the fund and the market move in the same direction. When the market rises, the fund usually gains, and when the market falls, the fund tends to decline. Most equity mutual funds have a positive Beta.

• Negative Beta: A negative Beta means the fund moves in the opposite direction of the market. When the market falls, the fund may rise, and vice versa. Such cases are uncommon and usually apply to specialised or hedging funds. Inverse or short equity ETFs can exhibit negative beta over the rebalancing frequency they are designed for (often daily). Over longer horizons, these betas may drift because of rebalancing and compounding effects. Commodities such as gold typically show low and time-varying betas relative to equities, not a reliably negative beta.

Here’s how different Beta magnitudes reflect a fund’s volatility and performance behaviour concerning the market benchmark.

• Beta = 1: The fund moves with its benchmark index, reflecting average market volatility and balanced risk-return potential.

• Beta > 1: The fund is more volatile than the market. For example, a Beta of 1.6 means the fund moves about 60% more than its benchmark, rising faster in bull markets and falling harder in downturns.

• Beta < 1: The fund is less volatile than the market. A Beta of 0.8, for instance, indicates movements about 20% lower than the benchmark, offering smoother returns for conservative investors.

The Significance of Beta in Mutual Funds

Beta plays a crucial role in mutual fund investing by guiding investors in understanding a fund’s sensitivity to market shifts and improving risk management decisions. The following points highlight its key significance:

• Portfolio Diversification: Investors can use Beta to balance their portfolios. Combining high-Beta and low-Beta funds helps balance risk exposure and achieve a mix of stability and growth potential.

• Risk Attribution: For fund managers, Beta shows how much of a fund’s ups and downs are due to overall market movements rather than the manager’s own investment choices. To see how well the manager performs, investors look at Alpha (also called Jensen’s Alpha), which measures how much extra return the fund earns compared to what its market exposure alone would predict.

• Aligning with Risk Appetite: Beta assists investors in selecting funds that match their comfort level with risk. Risk-averse investors may prefer funds with a Beta below 1 for steadier returns, while those with higher risk tolerance may opt for funds with a Beta above 1 to capture higher gains during market rallies.

• Role in Risk Management: Beta is important in managing investment risk. Low-beta funds tend to limit losses during market downturns, while high-beta funds can maximise potential gains in bullish phases. This makes Beta a useful factor in long-term portfolio planning.

How to Calculate Beta for a Mutual Fund?

To understand Beta clearly, looking at both the simplified and actual calculation methods is helpful. The following formula of calculating the Beta provides a basic idea of how the fund’s excess returns (over the risk-free rate) compare to the benchmark's:

Beta = (Fund Return – Risk-Free Rate) ÷ (Benchmark Return – Risk-Free Rate)

Where:

• Fund Return: Refers to how much the mutual fund has earned over a chosen time frame, based on its performance and underlying holdings.

• Benchmark Return: Represents the percentage gain or loss of the benchmark index (like the Nifty 50 or Sensex) during the same period, serving as a comparison standard for the fund.

• Risk-Free Rate: Indicates the return from a completely safe investment option, usually government bonds or Treasury bills, which carry minimal default risk.

The above formula can also be interpreted as follows, such that built-in formulas in platforms, like Excel, can be easily applied to calculate Beta accurately:

Beta = Covariance (Fund’s Returns, Benchmark’s Returns) ÷ Variance (Benchmark’s Returns)

Where:

• Covariance shows how the fund’s returns move together with the benchmark’s.

• Variance measures how much the benchmark’s returns fluctuate over time.

In actual analysis, Beta is calculated statistically using regression analysis.

• The excess monthly returns of the fund (Y-axis) are plotted against the excess monthly returns of the benchmark (X-axis).

• The slope of the best-fit regression line through these points represents the fund’s Beta value.

This can be done easily in Microsoft Excel using the Regression tool under the Data Analysis tab. Install the Analysis ToolPak from Excel’s add-ins section if it's not visible.

Let’s take a simple example to understand this better:

Covariance between the fund’s returns and the benchmark’s returns = 0.0025

Variance of the benchmark’s returns = 0.0020

Now applying the formula:

Beta = Covariance ÷ Variance

Beta = 0.0025 ÷ 0.0020

Beta = 1.25

This means the mutual fund’s Beta is 1.25, 25% more volatile than the benchmark. If the benchmark (say, Nifty 100) rises by 10%, the fund is expected to increase by about 12.5%. Similarly, if the market falls by 10%, the fund may drop by 12.5%.

Beta vs Other Ratios in Mutual Funds

Evaluating a mutual fund’s performance involves more than just looking at Beta. These are some key metrics often compared with Beta:

1. Beta vs Standard Deviation

   Standard deviation measures how much a fund’s returns vary from its average return over time. A higher standard deviation indicates larger fluctuations and, therefore, higher risk. Beta reflects how a fund moves in relation to the market. Standard deviation, on the other hand, measures the fund’s overall volatility, including both market-wide and fund-specific risks. It assists stakeholders in determining the reliability of returns under diverse market conditions. Beta measures systematic risk - the portion of a fund’s volatility explained by market movements. It does not measure the total risk; investors can use standard deviation to capture total volatility.

2. Beta vs Sharpe Ratio

   The Sharpe ratio measures how effectively a fund generates returns compared to the level of risk it takes. It is calculated by subtracting the risk-free rate from the fund’s average return and dividing it by the standard deviation. A higher Sharpe ratio means the fund offers better returns for the amount of risk undertaken. Unlike Beta, which shows volatility relative to the market, the Sharpe ratio highlights how well the fund rewards investors for the risks assumed.

3. Beta vs P/E Ratio

   Beta highlights a fund’s sensitivity to market movements, whereas the Price-to-Earnings (P/E) ratio focuses on valuation. Portfolio P/E indicates the valuation tilt of the underlying stocks; it reflects the weighted average P/E of the companies in the fund, not the fund’s earnings. A higher P/E ratio often reflects a growth-oriented portfolio that may be relatively expensive, whereas a lower P/E ratio points to a more value-driven or conservative approach. It is important to note that the P/E ratio is not a risk metric and should be viewed separately from beta. 

4. Beta vs R-Square

   Beta measures how much a mutual fund’s returns move in response to overall market changes. R-Square shows how closely those movements match the benchmark index. The R-Square value ranges from 0 to 1. A higher value means the fund’s returns follow the benchmark closely, while a lower value suggests weaker correlation. 

   For instance, index funds usually have a high R-square because they are designed to track the benchmark. In contrast, actively managed funds may show lower values due to independent stock selection. 

Things to Keep in Mind About Beta in Mutual Funds

When analysing mutual funds, Beta should be interpreted with care. The points below highlight the key aspects investors need to remember:

• Beta Reflects the Past: Beta is derived from historical data and does not predict future results. Market trends or fund strategy changes can affect a fund's behaviour over time.

• Benchmark Selection Matters: The reliability of Beta depends on choosing the right benchmark. The Beta value may give a false impression if the benchmark does not match the fund’s investment approach.

• Time Frame and Data Frequency Affect Beta: The time period and the frequency of returns used for calculation influence the Beta value. Shorter periods show more variation, while longer periods provide a clearer trend.

• High Beta Has Dual Implications: Funds with high Beta may gain more when markets rise, but can also lose more when markets fall. It represents both higher opportunity and higher risk.

• Beta Should Not Be Used Alone: Beta is only one part of evaluating a fund. It should be considered along with other measures such as alpha, fund performance, expenses, and investment goals.

• Beta Can Change Over Time: A fund’s Beta is not constant. It may vary as the portfolio composition or market environment changes, so it should be reviewed occasionally.

Key Takeaways

Beta reflects how a mutual fund’s returns move in relation to the market, helping investors gauge the fund’s volatility and risk level compared to its benchmark. It is calculated statistically by dividing the covariance of the fund’s returns with the market by the variance of the market’s returns or by using regression analysis to find the slope between them. Investors should interpret it alongside key metrics such as Alpha, Sharpe ratio, Standard Deviation, and R-squared to effectively assess overall risk-adjusted returns and portfolio suitability.