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Beta is a statistical estimate of a fund's volatility by comparison to that of its benchmark, i.e. how sensitive the fund is to movements in the section of the market that comprises the benchmark. A fund with a Beta close to 1 means that the fund will move generally in line with the benchmark. Higher than 1, and the fund is more volatile than the benchmark, so that with a Beta of 1.5, say, the fund will be expected to rise or fall 1.5 points for every 1 point of benchmark movement.
If this Beta is an advantage in a rising market - a 15% gain for every 10% rise in the benchmark - obviously the converse is the case when falls are expected. This is when managers will look for Betas below 1, so that in a down market the fund will not perform as badly as its benchmark.
It's important to stress that Beta is just an estimate: however, the stronger the R-Squared correlation between fund and benchmark, the more reliable this estimate becomes.

Worked Example: The impact of high Alphas and low Betas in differing market conditions
Alpha can be viewed as a measure of the performance a manager adds to a fund in excess of the returns that the market would have produced anyway. In a rising market, higher Alphas can identify those funds that will take greater advantage in conditions where some managers may be content just to sit back and settle for the systemic gains.
By contrast, in a falling market, a more defensive position is often sought. Funds with lower Betas – below 1.0 – will move downwards at a proportionately slower rate than that of the market, and so mitigate loss. By the same token, the lower Beta funds will participate in upside gains at a similarly diminished rate.
This exercise examines what happens to these two types of fund in two discrete calendar years that exhibited very different market conditions. (And there is no reason to choose these particular funds, other than that they illustrate our example quite strongly.)

Bear Market: 28 February 2001 to 28 February 2002
The following table shows our key ratios from the period for two very dissimilar funds; their IA sector is also included.

Table 16. Ratios table (from 28 Feb 2001 to 28 Feb 2002) against benchmark "UT UK All Companies" (risk free rate at 3.5%) of UT UK All Companies Sector from Unit Trust/OEIC universe
Name Alpha Beta R-Squared
Cavendish Opportunities TR 13.62 1.63 0.84
Sector: UT UK All Cos TR 0 1 1
Morgan Stanley UK Equity TR -2.35 0.61 0.84

In both cases, there is a strong r-squared correlation between the funds and the sector benchmark, which means that we can place some reliance in the other ratios. There is a marked difference in their Betas: for every 1 point fall in the benchmark, the Cavendish offering is set to drop 1.63 points, whereas Morgan Stanley's fund would lose only 0.61 – more than a full point's difference. So Morgan Stanley's investors should be carrying less than two thirds of the benchmark's downside. To see how this translates into performance, we have a further table:

Table 17. Total return performance (from 28 Feb 2001 to 28 Feb 2002) of UT UK All Companies Sector from Unit Trust/OEIC universe
Name Period Performance Sector Ranking (of 235)
Morgan Stanley UK Equity TR -10.06 47
Cavendish Opportunities TR -11.38 71
Sector: UT UK All Cos TR -12.97 113

Very few funds have prospered in this Bear market (only 7 out of the sector's 235 avoided a loss), with the group as a whole dropping almost 13 points. But the Cavendish fund hasn't been as heavily punished as its Beta would suggest, and Morgan Stanley's hasn't got off as lightly. A clue to this lies in the corresponding Alphas: the Cavendish high Alpha is evidence of very active management to mitigate the systemic forces, while Morgan Stanley's negative ratio indicates that they may not have intervened sufficiently to make the most of their advantageous Beta.
The figures do, though, broadly bear out the impact of a lower Beta in this market. Morgan Stanley's fund has performed better than the Cavendish, and was comfortably ahead in the sector rankings. For the bad times, so far, so good. But what happens to these clearly different management styles when conditions improve? This brings us to our next section.

Signs of recovery: 28 February 2003 to 28 February 2004
The following table re-examines the Alphas and Betas to see whether the disparity between the approach of the two fund managers was maintained.

Table 18. Ratios table (from 28 Feb 2003 to 28 Feb 2004) against benchmark "UT UK All Companies" (risk free rate at 3.5%) of UT UK All Companies Sector from Unit Trust/OEIC universe
Name Alpha Beta R-Squared
Cavendish Opportunities TR 10.69 1.73 0.84
Sector: UT UK All Cos TR 0 1 1
Morgan Stanley UK Equity TR -1.65 0.98 0.92

Morgan Stanley have raised their Beta, so the fund will track any sector gains more closely than before. Also, they have increased the Alpha but, despite this, they are still not generating a positive return over the benchmark; this speaks of a passive tracking strategy which lets the Beta proximity produce whatever gains the market has to offer. Cavendish have increased their Beta – accelerating participation in systemic returns – while dropping back on the level of positive Alpha. The Alpha level still suggests a very actively managed portfolio, but with a reduced degree of intervention so as to ride the rising market.
With our final table, we can see again what effect this had on performance.

Table 19. Total return performance (from 28 Feb 2003 to 28 Feb 2004) of UT UK All Companies Sector from Unit Trust/OEIC universe
Name Period Performance Sector Ranking (of 303)
Cavendish Opportunities TR 82.51 2
Morgan Stanley UK Equity TR 35.55 145
Sector: UT UK All Cos TR 39.7 99

It's clear that, unlike the marginal differences in return from our previous example, the outcomes here are dramatically at odds. The still-conservative Beta, in conjunction with negative Alpha, has Morgan Stanley slipping considerably down the rankings, while failing even to match the return that the sector average produced. The Cavendish approach, in stark contrast, has lifted the fund to the sector's no. 2 slot, and rewarded its investors with an 82% gain in the space of a year.
In summary, then, we have seen how a low Beta can provide a defensive home, mitigating the losses that could all too easily be incurred in a falling market. Conversely, this type of fund struggles when markets are recovering, and it is the high Alpha funds that take maximum advantage in an upturn.
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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.

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