Whiteboard Video Series: What is Beta?
Watch this short 4-minute educational video to learn more about beta and what it means for your client portfolios.
As part of our ongoing University of Alts content library, today we are going to cover Beta.
As always, we'll start with a definition. Beta is a measure of an investment's sensitivity to moves in the broader market. It can also be viewed as a measure of an investment's market-related or systematic risk.
Next, let's talk how about to analyze beta and why it is an important metric to take into consideration, especially when comparing funds in the alternative space. First, we must note that the market as a whole will always have a beta equal to 1. This is important because the beta of a subject investment will always be in relation to this number.
When analyzing a fund's beta, those that have a beta greater than 1 will tend to exhibit greater volatility than the overall market, while funds with a beta less than 1 will typically be less volatile. For this reason, beta is an important metric to take into consideration, because by identifying how volatile a fund is expected to be relative to the broader market we can efficiently target funds based on our desired level of risk as we build a portfolio or make recommendations for a specific client.
The concept of relative risk and volatility when analyzing fund options is highlighted in the following example. First, it's worth noting that unlike some other commonly used statistics, beta is not a simple back-of-the-napkin calculation. Rather, it involves dividing the covariance of a portfolio relative to its benchmark by the variance of the benchmark.
So, now let's look at an example of beta and how it relates to an investment's expected risk and return. In this example, we have Fund A with a beta of 0.7 and Fund B with a beta of 1.3. Using these figures, we would expect Fund A to be 30% less volatile than the market and Fund B to be 30% more volatile. Therefore, if the market were to move up 10%, we would expect Fund A to return 7% and Fund B to be up 13%.
While this may sound great, it is important to note that it also works in a similar way during market declines. In an environment where the market is down 10%, Fund A should protect capital more effectively and be down only 7%, while Fund B will be down 13%.
Like all other investment metrics, beta is not going to give you the answer to which fund is better than another, but it can provide some insight into what to expect from a volatility and return perspective, going forward. In addition, it can be a way to keep your manager honest and make sure that if they are delivering a higher beta with a higher market-related volatility that the returns of the fund are also there to back it up.