Beta Management

A fund manager has two separate jobs, and the workbook splits them apart.

One is alpha management: earning more than the market by picking well. The other is beta management: deciding how much market risk the fund carries in the first place.

Beta measures how much a fund's return moves when a broad index moves. A high beta fund swings harder than the index. A low beta fund swings less.

Here is the point. Beta is not a by-product. It is a choice. A fund that buys small-cap and mid-cap shares has taken on a high beta, whether or not the manager meant to. And that risk cannot be diversified away by spreading across industries, sectors or countries.

So the manager owes the investor a promise. The private placement memorandum says what the strategy is. The beta of the portfolio has to match that promise.

High beta helps in a rising market and hurts in a falling one. Managing beta means deciding how aggressive to be, and when.

Section 6.8.2 sets the manager's duty plainly: an investment manager is responsible to manage the systematic risk of the fund commensurate with its investment strategy as stated in the Private Placement Memorandum.

Where beta comes from. Beta measures systematic risk — the change in the returns earned by the fund portfolio on account of a change in the returns on a broad-based index. The higher the beta, the more volatile the portfolio is compared with the market return. The workbook's illustration: a fund taking long positions primarily in small-cap and mid-cap securities will have a high overall portfolio beta, while a fund taking long positions in large-cap securities will have a lower one. That difference comes from the inherently risky nature of the underlying shares, and it cannot be diversified by investing across industries, sectors and geographies.

Category III AIFs are the sharp case. They may carry a higher implicit beta if the manager invests in highly volatile equities.

The timing rule. High beta investments are likely to outperform the benchmark during bull markets and likely to underperform during bear markets. So the manager of a small- and mid-cap fund should be more aggressive during bull markets than the manager of a large-cap fund.

Where beta management sits. It follows from return attribution. Identifying the source of return tells the manager two things: the sources of alpha, being the factors leading to outperformance, and the quantification of beta, being the sensitivity of the portfolio to market risk factors. Return attribution therefore feeds portfolio construction, future alpha generation and portfolio beta management.

The workbook's worked case (Example 4) gives an institutional investor holding:

The investor considers moving half the large-cap holding — 20% of the portfolio — into a domestic Category III AIF whose own strategy is 25% net long large-cap, 35% net long mid-cap BFSI, 30% long small-cap pharmaceutical growth stocks and 10% money market instruments.

The workbook's verdict is that the reallocation should be considered, because it can potentially increase alpha provided it stays within the acceptable level of systematic risk and the manager predicts a bull market in the near term. And because the AIF's mid-cap and small-cap exposures are in the same industries the investor already held, the overall portfolio beta is not substantially changed.

Nilgiri Long Only Fund, a Category III AIF, tells investors in its PPM that it runs a large-cap strategy with a target portfolio beta of 0.9 to 1.1. Its NAV is Rs 400 crore.

The manager's holdings at the start of the year:

That is inside the promised band.

Mid-caps then run hard. Six months later the mid-cap holding is worth Rs 96 crore and the large-caps Rs 344 crore, on an NAV of Rs 480 crore.

Still inside the band, but drifting. Nobody bought anything. The beta rose purely because the high-beta holding grew faster than the rest. That is why beta is something to be managed rather than set once.

If mid-caps double again to Rs 192 crore on an NAV of Rs 576 crore, the mid-cap weight reaches 0.333 and the portfolio beta reaches 1.12 — outside the PPM band. The manager must now trim mid-caps or add large-caps, whatever the manager's own view on mid-caps, because the promise in the PPM is the binding one.

And the workbook's timing point cuts the other way too. A manager who read the coming market as bearish would want the beta at the bottom of the band, not the top, because a high beta underperforms in a falling market.

Chapter 6 (Alternative Investment Funds in India and its Suitability), section 6.8.2, sits immediately after section 6.8.1 on Alpha Management, and the two are examined as a pair. Section 6.8 introduces both from the return-attribution angle.

Expect the conceptual question: who is responsible for managing the fund's systematic risk (the investment manager) and against what benchmark (the strategy stated in the PPM). Expect the small-cap versus large-cap comparison, and the direction rule — high beta outperforms in bull markets and underperforms in bear markets. Example 4 is the likely source of a case question asking whether a reallocation into a Category III AIF improves alpha and beta; the workbook's answer is yes on alpha, and largely neutral on beta because the industries overlap.

• Alpha management and beta management are different jobs. Alpha is excess return from skill or from taking unsystematic risk. Beta is the amount of market risk carried. Section 6.8.1 is one, 6.8.2 the other.
• Beta risk cannot be diversified away. Spreading a small-cap portfolio across industries, sectors and geographies does not lower its beta. That is the whole reason it needs managing.
• The benchmark for "how much beta is acceptable" is the PPM, not the manager's market view. A strategy disclosure is a commitment.
• High beta is not a mistake. It is appropriate in a bull market for a fund whose stated strategy is small and mid-cap.
• Portfolio beta drifts on its own. It changes when prices move, with no trade at all, because the weights change.
• In the workbook's Example 4 the beta barely moves — not because the AIF is low risk, but because the investor already held the same industries. Read what the existing portfolio holds before answering.