Investors always like to analyse different mutual funds on various parameters before making an investment decision. Two key factors they look at are the potential for return promised by the scheme and the risk profile. While investors can look at the past performance of a fund to analyse the first factor, they need a tool to measure the volatility of a fund. A popular metric used for this purpose is called beta.
What is Beta in Mutual Funds?
Beta is an analytical tool that measures the volatility of the mutual fund with respect to a benchmark index. It is essentially a numeric value that tells investors how much a mutual fund's value moves compared to the stock market. Investors can compare beta values of different mutual funds to find a suitable scheme that matches their risk profile and investment goals.
Types of Beta Values
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Positive Beta Value: This indicates that the mutual fund is moving in the same direction as the market. There are three possible scenarios:
- Beta = 1: The beta of any benchmark index is always valued at 1. Therefore, a beta value of 1 of a mutual fund indicates that it has the same volatility as the benchmark index. The fund carries average risk and is more likely to mirror the market’s movement.
- Beta > 1: If beta value is greater than 1 then this indicates that the mutual fund is more volatile than the benchmark index. The bigger the value, the greater the risk involved and the greater the potential of earning higher returns. If the value of beta is 1.3 then it means that the mutual fund will rise by 13% when the market rises by 10%.
- Beta < 1: If beta value is greater than 1 then this indicates that the mutual fund is less volatile than the benchmark index. The lower the value, the lesser the risk involved. If the value of beta is 0.5 then it means that the mutual fund will fall by 5% when the market falls by 10%.
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Negative Beta Value: A negative beta in MF indicates that the fund is moving in the opposite direction of the market. If the value of beta is -1 then it means that the mutual fund will rise by 5% when the market falls by 5%.
How Beta Works
Irrespective of whether you want to make a lumpsum investment or an SIP investment, you need to find out if the risk you want to take by investing in a mutual fund will be justified by the expected return from the investment.
The beta value can tell you in which direction the funds’ value is expected to move when its benchmark rises or falls by 1%. A high beta value means the potential of earning a higher return at a higher risk and a lower beta value means lower but stable returns. If you anticipate a bear market, choosing a fund with a negative beta value can be a great option.
Here’s the beta formula in mutual funds:
where, Covariance measures how the fund’s returns and index move together and Variance measures how the index’s returns fluctuate.
For instance, if the covariance between the mutual fund and the benchmark is 0.006, and the Variance of the benchmark is 0.003, then beta equals 2. This means that the fund is twice as volatile as the index.
Benefits of Beta Ratio in Mutual Funds
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Risk Assessment: Beta helps investors assess the volatility of a fund compared to the market. Investors can tailor their investments according to their risk tolerance.
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Performance Prediction: It indicates the potential for higher or lower returns based on the market. A higher beta suggests greater volatility and potential for higher returns in a rising market.
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Portfolio Diversification: It helps in portfolio diversification by identifying how different assets react to market movements. By combining investments with low-beta (less volatile) and high-beta (more volatile) assets, investors can reduce overall portfolio risk while potentially enhancing returns.
Limitations of Beta in Mutual Funds
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Only Measures Market-Related Risk: Beta only measures systematic risk. It completely ignores risks like individual stock performance or sector-specific issues.
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Uses Historical Data: Beta is based on past performance which, as you may already know, may not accurately predict future volatility or returns.
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Assumes Linear Relationship with Market: Beta in MFs assumes a constant relationship with the market, which may not always hold true in changing market conditions.
In conclusion, beta is a useful tool for investors to understand the risk profile of a mutual fund. By mixing funds with different betas, an investor can balance the overall risk in their portfolio. The important thing is to use other key metrics and ratios in addition to beta ratio in mutual funds to properly evaluate mutual funds and make informed investment decisions.
FAQs:
Q: What is alpha and beta in mutual funds?
A: Both alpha and beta are key performance indicators used to assess mutual funds. Alpha measures the performance while beta measures the volatility of a fund relative to the benchmark index.
Q: What is the meaning of a negative beta value?
A: A negative value of beta means that the fund is moving against the direction of the market. In a bull run, the mutual fund is likely to fall and in a bear run, the fund is likely to rise.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
