Financial Term of the week- Beta (β)

To understand Beta, let us understand the concept of a benchmark in mutual funds. Remember, how in school, the class topper would be your benchmark; similarly, every mutual fund scheme has a benchmark against which its performance is measured/gauged. Another way of putting it is to say that the scheme shall always try to achieve or beat the benchmark’s return. If the scheme does better than the benchmark, then it has outperformed and if it has done worse, then it has underperformed. The fund house declares the benchmark for every scheme and these benchmarks can be indices like NIFTY 50, S&P BSE 200, etc.

Now, Beta is a measure that tells you how much your chosen scheme will fluctuate in the face of market volatility, in comparison to its the benchmark index, i.e. to what extent. It measures the sensitivity/risk associated with the scheme with respect to that of its benchmark index caused by market volatility.

How to make sense of β?

Every mutual fund undertakes a certain amount of risk when it invests in various securities. Now, since it is the market’s nature to be volatile, the effectiveness of your fund’s portfolio is in how it performs when the market is volatile and β can help you to measure that. Beta denotes the sensitivity of mutual fund scheme towards market movements.

The β for all benchmark indices is taken to be 1. This means that if β for a scheme is 1, it will mirror its benchmark’s performance. If the β is greater than 1, the scheme may gain more than the benchmark or lose more than the benchmark, depending on the market volatility. Whereas, if it is less than 1, then chance of gain or loss is lesser than the benchmark index.

For example, if the β for a fund is 1.5, that will imply that the tendency of the scheme to fluctuate is twice that of its benchmark index, when the market is volatile. So, if the benchmark return is 10%, then the scheme can give you a +15% return in a good market situation and can also give you a -15% return in a not-so-good market situation. As can be seen, a higher than 1 β represents more volatility but also possible higher returns and vice versa for a β value of less than 1.

Things to keep in mind while looking at β

Ideally, investors with a lower risk appetite may want to consider a beta that is relatively lower or closer to 1.0 so that the performance fluctuation is lesser, relative to the benchmark in volatile markets. This may also depend on the nature of the market. If the market is high, a relatively higher beta may be favourable and vice versa.

Having said the above, a low β does not mean that the mutual fund scheme is less volatile. It means that it is less volatile than the benchmark index.

Rather than looking at β in isolation, it is recommended to consider all the parameters to measure the risk and return of mutual funds in conjunction with each other. Also, β can be a tool to compare two schemes in the same category that are benchmarked against the same index. In this case, the difference in β will tell you the amount of relative risk associated with each scheme.