Bullish on Betas

Should I seek out high-beta funds in today's market environment?

QUESTION: In this market, is it advisable to stay away from funds with betas that are less than 1.0 vs. buying a fund with a high beta, such as 1.5?

ANSWER: Sounds like you're pretty optimistic that this market is on the mend. After all, seeking funds with betas of 1.5 means that you're looking for funds that stand to gain 50% more than the S&P 500 (or some other benchmark). And should your call be wrong, you'd be invested in funds that could lose 50% more than the S&P 500.

But before we address whether this is a smart strategy, bear with us while we catch the non-beta-savvy up on what exactly you're suggesting here. Beta is a statistic of Modern Portfolio Theory, or MPT, developed in the 1950s by Harry Markowitz, who later won a Nobel Prize for Economics in 1990. As we mentioned above, beta measures the volatility of a fund against a specific benchmark. But before you can even use beta to evaluate a fund, you must first check another MPT statistic, R-squared. A fund's R-squared figure measures the degree to which movements in that fund are explained by movements in its benchmark index. Perfect correlation with an index is represented by an R-squared of 100, as in the case of the Vanguard 500 fund (VFINX) with the S&P 500 index.

Unless you're looking at an index fund, however, most funds obviously won't have an R-squared figure of 100. And if the fund moves too independently of the benchmark it's being compared to, then its beta figure is worthless. An R-squared of about 80 or higher enables you to use the beta figure with confidence, says Peter Di Teresa, senior analyst at fund-tracking firm Morningstar. Assuming the beta figure is valid, a fund with a beta of 1.25 would be expected to move 25% more than the index — either up or down — while a fund with a beta of 0.75 would theoretically move 25% less. And keep in mind, while our site compares each fund to the S&P 500, Morningstar also seeks out other indexes that might provide a better fit.

OK, now let's examine your strategy. Does investing in high-beta funds during a time when you think the market is about to experience gains make sense? Probably not, says Di Teresa, who generally shuns market timing. Ramy Shaalan, senior fund analyst at fund tracker Wiesenberger, agrees. After all, near-term recovery certainly isn't assured, and if the market dips further, Shaalan notes, a high-beta fund should drop further than other portfolios. And in any case, investors should avoid using a single fund statistic in isolation. R-squared and beta should be examined in conjunction with other data, from fund returns to expenses to manager experience.

So concentrate instead on finding solid funds with good track records that fit nicely into your portfolio. And this advice applies even if you do decide to take the high-beta route, Di Teresa says. No matter what, be sure to choose funds that you plan to stick with over the long term, hanging on during the ups and downs. Also, when purchasing the fund, use dollar-cost averaging in order to take advantage of price dips along the way.