Two key metrics are critical to evaluating a mutual fund’s suitability for your portfolio — namely, the risk and the returns. While a fund’s alpha helps you assess its risk-adjusted returns, the beta in mutual funds helps you evaluate the risk involved. If you want to compare mutual funds and make an informed decision, it is crucial to understand the meaning of beta in mutual funds, how it works and how to calculate and interpret it.
What is beta in a mutual fund
The beta in a mutual fund is a mathematical tool that measures the scheme’s volatility relative to its benchmark index. In other words, it tells you how sensitive the mutual fund is to changes in the broad mark. This helps you analyse the systematic risk associated with the fund.
Looking into the beta of a fund before you invest in it can tell you how much and in which direction the fund’s value may move when its benchmark rises or falls by 1%. Large movements indicate higher risk, while smaller changes indicate that the fund is relatively less risky.
A closer look at how beta works
Now that you know what the beta in mutual funds indicates, let us delve into the finer details of this analytical tool. Since the beta is based on the past performance of a mutual fund and its benchmark or the broad market, you can get a better idea of the fund’s historical risk.
When you are choosing funds for your portfolio, irrespective of whether you want to make a lump sum investment or start a SIP, you need to evaluate the beta and check if the risk taken is justified by the excess returns you earn from the fund — when compared with its benchmark. The alpha of the mutual fund quantifies this risk-adjusted return.
Why the beta is important in mutual funds
Beta is vital in mutual fund analysis because it helps you assess the level of risk in a fund relative to the market. You can use beta to understand the expected movements of a fund in relation to market changes. This, in turn, helps you make informed decisions about risk and return expectations and is essential for constructing a well-balanced portfolio.
For mutual fund managers, beta is a key tool for performance evaluation. By assessing a fund's beta, fund managers can determine how well they are handling the fund's volatility in comparison to the market. This helps them develop strategies that align with the fund's objectives — whether it's aiming for aggressive growth or stable income.
Additionally, beta values also help with portfolio diversification. By combining funds with different beta values, you can create a balanced portfolio that has well-distributed risk and the potential for enhanced returns.
Beta in mutual funds also plays a crucial role in risk management. By selecting funds with appropriate beta levels, you may tailor your portfolios to match your risk tolerance. For instance, during market downturns, funds with lower beta can help mitigate losses, while those with higher beta might offer more upside during bullish phases.
Types of beta values and what they mean
Interpreting beta values can seem complex for beginners because you need to assess the value as well as the direction of the result. However, this handy guide can help you interpret beta in mutual funds at a glance.
Beta = 1: A beta value of 1 means that the mutual fund is exactly as volatile as its benchmark. This limits the risk in the fund but also reduces the possibility of earning excess returns over and above the benchmark returns.
Beta > 1: If the beta in a mutual fund is more than 1, it means that the fund has more volatility than its benchmark. This increases the risk involved. For instance, a beta of 1.6 indicates that the fund moves 0.6 times or 60% more than its benchmark index.
Beta < 1: A beta value below 1 means that the fund is less volatile than its benchmark index. This translates to a low level of risk. For example, if a mutual fund has a beta of 0.8, it means the fund is 0.2 times or 20% less volatile than the benchmark considered.
Negative and positive beta: In addition to the absolute value of the beta in mutual funds, you must also check whether it is positive or negative. Positive beta values indicate that the fund and the market move in the same direction, while negative beta values indicate that the two move in opposite directions.
The formula for calculating the beta value in mutual funds
The beta in a mutual fund is a ratio of two statistical measures. The numerator is the covariance of the mutual fund’s returns with the benchmark’s returns over a given period, while the denominator is the variance of the benchmark’s returns over the same period. This leads us to the following beta formula in mutual funds:
Beta = (Covariance of the fund’s returns with the benchmark’s returns) ÷ Variance of the benchmark’s returns
The covariance in the numerator measures how the fund’s returns change relative to the benchmark index’s returns. The variance in the denominator of the beta formula in mutual funds tells you how much the benchmark’s returns vary in the given period.
Calculating beta: An example
Let us discuss an example to understand how to calculate beta. Let us say the covariance between the returns of a mutual fund and the returns of its benchmark index is 0.0025. The covariance measures how much two variables change together. In this context, it shows how the returns of the mutual fund move in relation to the benchmark’s returns.
Next, we need the variance of the benchmark’s returns, which measures how much the benchmark’s performance fluctuates over time. Let us assume this is 0.002.
Substituting these values in the beta formula for mutual funds, this is what we have.
Beta:
= (Covariance of the fund’s returns with the benchmark’s returns) ÷ Variance of the benchmark’s returns
= 0.0025 ÷ 0.002
= 1.25
This means the beta of the mutual fund is 1.25. In other words, the mutual fund’s volatility is 25% more than its benchmark. If the benchmark’s return changes by 1%, the fund's return is expected to change by 1.25%.
Beta value and mutual fund categories
Different types of mutual funds typically have varying beta values based on their investment strategies and objectives. For instance, equity funds may often have higher beta values — even above 1 — because they are more volatile than other securities. Index funds may have a beta closer to 1 because their volatility is closely linked to their benchmark index. Debt funds, on the other hand, may have beta values below 1 because they are rarely, if at all, more volatile than the market.
Even within the same fund category, different schemes may have different beta values. For instance, check out the beta values for the following mid-cap equity mutual funds schemes (As on May 27, 2024):
Motilal Oswal Midcap Fund Direct - Growth: 0.78
HDFC Mid-Cap Opportunities Direct Plan - Growth: 0.88
Nippon India Growth Fund Direct - Growth: 0.94
Quant Mid Cap Fund Direct - Growth: 1.01
The category average for this segment is 0.91. As you can see, even funds within the same category, like the mid-cap equity mutual funds listed above, can exhibit significantly different beta values. This suggests that each fund has a unique risk-return profile and investment strategy.
These differences in beta values can be traced back to various factors such as the fund's asset allocation, stock selection criteria, market timing and investment strategies. You need to consider these differences along with your own risk tolerance and investment objectives when you are investing in mutual funds for your portfolio.
Things to keep in mind about beta in mutual funds
Here are some important things you need to keep in mind about beta before you invest in mutual funds:
Relative risk measure
Beta is a relative measure that compares a mutual fund's volatility to the broader market. It can give you some information about a mutual fund’s risk levels on a standalone basis, but you may also use it to compare how a fund’s volatility compares to the industry or category average.
Beta-based diversification
You may even use beta values to diversify your portfolio. By including funds with different beta values, you can balance out the overall risk in your investments. For instance, combining high-beta funds with low-beta funds can help mitigate risk while potentially enhancing returns.
Link to market conditions
Beta values are not fixed. They can vary based on market conditions. During bull markets, for instance, high-beta funds may outperform the market while low-beta funds may lag. In bear markets, the opposite is often true.
Long-term outlook
You need to remember that beta in mutual funds is only one part of a broader investment strategy. While low-beta funds may offer more stability, they may also provide lower long-term returns. However, while high-beta funds may offer greater growth potential, they are riskier.
Conclusion
This sums up what beta in mutual funds is and how you can compute and interpret it. If you are a conservative investor, you may want to consider funds with a low beta value. On the other hand, if you are comfortable taking risks, a fund with a high beta may also be suitable for you — provided its risk-adjusted returns are high.
Irrespective of your risk tolerance and beta preferences, you can find a suitable mutual fund scheme for your portfolio on the Bajaj Finserv Mutual Fund Platform. With more than 1,000 schemes available to choose from, comparing and making an informed choice has never been easier.
