ALPHA IS THE ALPHA AND OMEGA OF MUTUAL FUND SELECTION

BETA TODAY, ALPHA LATER

This post will revisit Beta, one of the the topics of the December Desert of the Real Newsletter. Alpha and Beta may be difficult to understand. But they are topics that will aid you in selecting better performing mutual funds. In this Secular Bear Market, lower Beta and higher Alpha mutual funds should perform better and give investors a chance at absolute, real returns.

BETA IS A “SHORTHAND” MEASUREMENT OF VOLATILITY

Beta compares the volatility of a particular mutual fund (or stock) against the movements of the S&P 500 Index. Volatility, you will recall, is the fluctuation of the value of an investment, going up or down in value. If the S&P 500 Index goes up 5% last year, and Acme Growth and Income Mutual Fund went up 5% in that same year, then Acme will have a Beta of 1.0. This is because the volatility of the S&P fund, its movement up or down in a given year or period of time, is assigned the value of 1. 1 is the mathematical baseline of Beta.

So in thinking about the Beta of the S&P 500 for last year, the value of 1 really means that the S&P 500 went up 5%. The Beta value of 1 just gives us a baseline measure of the S&P 500’s volatility that we can simply and quickly compare with other investments.

For this first example, we only looked at the Beta of the S&P 500 for one year. However, the S&P 500 Beta is based upon years of prior movement. Beta can be thought of as a moving average. And since the S&P 500 is a common index that tracks the movement of many stocks, it is considered a broad measure of the market as a whole. So the Beta of the S&P that is assigned the value of 1 equals a figure that reflects the percent that the S&P 500 fluctuates year to year.

BETA AS A COMPARISON TO OTHER INVESTMENTS

In the December Newsletter, we looked at two hypothetical mutual funds. The Slow and Steady Value Fund and the Afterburner Tech Stock Fund. We wanted to look at the volatility of these funds. Here is what we found:

If Slow and Steady Value Stock Mutual Fund has a beta of .8, that means that the mutual fund is only 80% as volatile as the S&P 500. This fund only moves 80% in value in comparison to the S&P 500. So it the S&P was up 5% for the past year, Slow and Steady would have been up 4% (5 * 80% = 4). However, if the S&P were down 7.21%, then Slow and Steady would have only fallen by 5.77%.

Afterburner Tech Stock Fund has a beta of 1.25. This means that this mutual fund is 25% more volatile than the S& P 500. So if the S&P 500 rises by 9%, then Afterburner would be up by 11.25%. But if the S&P nosedives by 13.3%, then Afterburner will sink by 16.625%.

There is nothing intrinsically bad about either a high or a low beta. And either fund above, Slow and Steady and Afterburner, would have their place in a portfolio at certain times and/or under certain conditions. So which fund do we want and when?

WHEN THE STOCK MARKET IS GENERALLY FLAT OR FALLING, KEEP THE BETA LOWER.

In a Secular Bear Market such as we face, a low Beta investment is the preferred choice. In an environment when there are more losses than gains, we want to avoid big losses and eke out gains when we can. The low Beta Slow and Steady Fund will be our better choice. If the S&P 500 is more likely to go down than up, then a high Beta fund will magnify our losses, while a low Beta investment will minimize our losses. Let’s crunch some numbers:

Remember for the following example that Afterburner Tech Stock Fund has a Beta of 1.25. That means that it is 25% MORE volatile than the S&P 500. Slow and Steady Value Fund, by contrast, has a Beta of .8. That means it is only 80% as volatile as the S&P 500.

Year One. In Year One we put $1000 in each fund. The S&P 500 loses 12% in Year One. Since Afterburner has a Beta 1.25, it will fall 15% when the S&P 500 loses 12% (12% S&P Loss * Beta 1.25 = 15%) So Afterburner will fall to $850.

Slow and Steady will also fall, but it will only fall to $904. (12% S&P Loss * Beta .8 = 9.6%).

Year Two. In year two the S&P 500 slips another 4%. Afterburner will lose another 5% (4% S&P Loss * Beta 1.25= 5%) and Slow & Steady will lose 3.2% (4% S&P Loss * .8 Beta = 3.2%). So Afterburner slips to $807.25 and Slow and Steady goes to $875.

Year Three. In year three the S&P 500 is up 5%. Afterburner will rise to $857.70 (5% S&P Gain *1.25 Beta = 6.25%) and Slow and Steady will increase to $910. So Slow and Steady wins this race.

AFTERBURNER WINS THE BLOWOUT, HOWEVER.

If the trends of the S%P 500 moved in the other direction, with large gains most years and only a few years with small losses, Afterburner’s higher Beta would work to its advantage and make it the clear winner. So the logic of when to employ each fund is clear. In a Secular Bull Market, the more volatile fund is poised to give you better returns. But in a Secular Bear Market, a less volatile fund will prevail.

Of course an even better strategy is to hold investments that will rise in value when stocks fall, such as shorts, puts and inverse funds. But as an illustration of the effects of a mutual fund’s Beta, the foregoing stock comparison tells much of the story.

We will look at Alpha in a future post and see how Alpha in combination with Beta can help you select investments that will have lower Betas and Higher returns..

BOOK EARLY TO AVOID LONG LINES IN THE DESERT OF THE REAL!