Beta is the measure of a fund's volatility relative to the market or benchmark. A higher beta implies higher volatility

It is common knowledge that mutual funds are benchmarked against particular market indices. In general, diversified funds are benchmarked against Sensex or Nifty, while sectoral funds are benchmarked against their particular sector index. It is fair to then assume that the ups and downs of any index will affect the funds that are benchmarked against it. In other words, if the Sensex falls, you can expect a diversified fund to fall as well.

But while some funds might be affected more by an index's volatility, others might not. So, then how does an investor get an idea of how volatile a fund is with respect to its index?

Here is where beta enters the picture. Beta is the measure of a fund's (or stock's) volatility relative to the market or benchmark.

For example, if a fund is benchmarked against the Sensex, a beta of more than 1 would imply that the fund is more volatile than the index. And of course, a beta of less than 1 would imply lesser volatility.

Allow us to explain further. Let's say there are two funds, one with a beta of 2.5 and the other with 0.4, both benchmarked against the same index. Now, if the market rises by 1 per cent, the first fund will rise by approximately 2.5 per cent, while the latter will rise by 0.4 per cent. A similar relationship will take place in a falling market. In simpler words, beta is a quantitative measure of a fund (or stock) relative to the market.

In effect, beta expresses the fundamental trade-off between minimizing risk and maximising return. This means that while an investor can expect high returns from a fund that has a beta of 2, he can also expect the fund to be more risky and drop much more when the market falls. A fund with a beta of 1 would flourish or diminish in the same vein as the market.

So, how effective is beta in judging a fund's volatility? Well, that depends on the index used to calculate it. If the beta of a large-cap fund is calculated against a mid-cap index, the resulting value would have no meaning. This is because the large-cap fund would not be invested in the stocks making up the small-cap index.

Beta is fairly straightforward and offers a lucid, quantifiable and convenient measure of a fund's volatility. However, beta does have its limitations. Beta is essentially a historic tool and does not incorporate new information. For example, a company may venture into a new business and assume a high debt level, but this new risk will not be captured by beta. Beta relies on past movements and does not take new happenings into account. Hence, beta cannot be calculated for new funds or stocks that have insufficient history.

In conclusion, investors should remember that beta is just an indication of a fund's (or stock's) volatility. It gives a fair idea of the same and can be used as a reference, but should not be relied upon completely since beta depends on past movements, which are not fool proof predictors of future behaviour.