Beta answers the question, “When markets go up or down, does the manager typically go up or down more than the market or less than the market?” This is what is meant by market sensitivity. Beta is also used to quantify market risk, sometimes known as “systematic risk”.
The starting reference point for beta is 1.0. If a manager has a beta of 1.0 to the benchmark, the manager doesn’t tend to go up more or less than the market when the market moves. A more conservative manager who tends to trail in up markets but has downside protection in falling markets would have a beta less than 1.0. An aggressive manager who did very well in up markets but tended to lose more in down markets would have a beta greater than 1.0. Therefore, the definition of “good” depends upon whether the investor is conservative or aggressive.
Beta does not distinguish between up and down markets. Ideally one would want a manager who was up more than the benchmark when markets were up but down less than the benchmark during down markets. However, beta only measures overall sensitivity and does not differentiate between up and down markets.
Both graphs below share the same starting point, with rolling benchmark returns in black. As the black line for the benchmark oscillates between periods of gains and periods of losses, the two managers react differently. In the upper graph the manager in red tends to do very well when markets are up, but when markets are down the manager performs worse than the benchmark. The red manager is sensitive to market movements and would exhibit a beta higher than 1.0. On the other hand, the blue manager lags the benchmark when the market is up but tends to offer downside protection when the market is down. The blue manager has a beta less than 1.0 and isn’t as sensitive to market movements.
The information below shows the typical range of mutual fund betas relative to the appropriate benchmark. Across most asset classes, the middle range of the distribution (funds in between the 25th and 75th percentiles) have betas close to 1.0. This means that most funds aren’t over- or under-sensitive to market movements. The betas are more interesting in the tails. The ranges seem to be tilted towards lower betas, meaning that there are more conservative managers than aggressive managers.
The numerator of beta measures how the manager return moves relative to the benchmark movements. The denominator scales the results of the numerator so that the point of reference of beta is 1.0.
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