Mutual Funds Day 38: The Technicals of Diversification, Beta β + Systematic Risk.
In the last Chapter, we learned the need for diversification, if you have not read it yet, please do so.
https://medium.datadriveninvestor.com/mutual-funds-day-37-the-need-for-diversification-07ac7f54e624
In this Chapter, we will learn a bit about the technical aspects surrounding diversification. Mutual Funds are inherently the best diversification financial instrument ever invented. MFs pool money from the public and then invest in a basket of stocks or assets.
Introducing the Greek variable Beta β that tracks the volatility/risk of a stock. For the benchmark, β is set to 1. In our case, the β of Nifty50 or Sensex is set = 1, and all other stocks or mutual funds would have a value either equal, greater than, or lesser than 1.
- If β > 1, it means the stock or mutual fund is more risky than the benchmark (Nifty 50).
- If β < 1, it means the stock or mutual fund is less risky than the benchmark
- If β = 1, it means the stock or mutual fund has the same risk as the benchmark.
If you examine an index like Nifty50, it has 50 component stocks and each of the stocks has a β.
- HDFC Bank, β = 1.13
- RELIANCE, β = 1
- ITC, β = 0.64
If we add up all the component stocks of the index and then take the weighted average, β will be equal to 1. Similarly, all mutual funds have β calculated, for example:-
SBI Focused Equity fund has a beta of 0.72.
Quant Small Cap fund has a beta of 1.06.
Axis Bluechip fund has a beta of 0.91
The higher the Beta, the riskier the mutual fund. Most of the time a higher risk MF is required to generate returns higher than the benchmark. But beta cannot be read in isolation and the other ratios like Standard Deviation, Sharpe ratio, Treynor’s Ratio, and Jensen’s Alpha have to be read along with Beta to pick the right mutual fund. We will discuss them in the later chapters.
Usually, the fund manager prefers to keep the β as close to 1 as possible. This is to lower the risk. We would also like to introduce the term “Systematic Risk” here.
Systematic Risk is also called undiversifiable risk, meaning there is no way a fund manager can control the losses. The entire market will be at risk and usually, the events could be
- Wars
- Inflation
- Interest Rate changes
- Recession
- Terrorism
- Natural Calamity
This impacts the entire market and technically it may not be possible to handle this risk by just selling or buying stocks and may require hedging via derivative instruments.
For all other risk types, the β plays an important role. The closer it is to 1, the mutual fund will stay as correlated to the benchmark as possible. If it is higher than 1, then the risk may create a heavier loss.
There are 2 components here —
- Returns
- Risk
For the past many years, our markets have only gone up, so it is quite possible that you as a customer would have studied only the returns profile and not the risk ratios. Only when the markets turn, fall, or get into a bear market — you will be forced to assess the risk. Please be informed that returns are to be read along with their risk to know what you are getting into as markets may not be as generous as you think.
Next Chapter
https://medium.datadriveninvestor.com/mutual-funds-day-37-the-need-for-diversification-07ac7f54e624
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