Rising Betas at Some Funds Could Indicate New Risk

This article previously appeared in  Morningstar FundInvestor.

Even two years after the end of the most recent and destructive bear market (2007–09), investors are skittish about equities. Proof of that can be found in fund-flow trends during the past several years--bond funds have been raking it in while stock funds have seen redemptions.

Regardless of the attractive valuations that bear market may have left in its wake and the market's healthy rebound in 2009, investors' anxiety is understandable. Both 2010 and 2011 have seen their share of bumps. Most recently, the S&P 500 Index dropped 5.43% in August 2011--a month that included one of the craziest weeks in recent history following S&P's U.S. debt downgrade and that ended up being the worst monthly performance since last spring.

One solution might be to look for a low-beta fund. Beta measures how a portfolio has reacted to changes in the overall market, represented by an appropriate index; a higher beta means the portfolio's moves have been more exaggerated than the index's, while a lower beta means its changes have been more subdued. A beta of 1.00 means it is equal to the index. Choosing a low-beta fund may mean accepting smaller gains in rallies but also smaller setbacks in down markets.

There are some limitations to beta. For example, most figures are calculated using monthly data, but especially lately, lots of volatility occurs during the month. And as is the case with trailing returns, one snapshot in time may not tell the whole story. While the following funds might seem like good candidates based on their reputations or their long-term history, their three-year betas have actually been rising in the past decade, so they are not appropriate for anyone who doesn't feel comfortable holding on during rough patches.

 Fairholme Fund  (FAIRX)
Over the past 10 years, Fairholme's beta has nearly tripled. In fact, its beta since the end of 2008 has been greater than 1.00. One culprit is manager Bruce Berkowitz's investments in financials stocks, which have been particularly volatile over the past several years. Berkowitz has long been a value-oriented contrarian, and his current portfolio shows his stripes haven't changed. In addition, redemptions have cut the fund's cash position dramatically. The fund's recently wild performance pattern and bold, highly concentrated portfolio suggest that a long-term investment horizon and greater risk tolerance are warranted.

 Fidelity Magellan  (FMAGX)
Under previous manager Bob Stansky, Fidelity Magellan's beta hovered right around 1.00. Stansky had run the gigantic fund as more of a closet indexer, so it's not surprising that things changed when Harry Lange took the reins in late 2005. With experience investing in smaller companies, Lange is more of a growth investor; he has thus added slugs of small- and mid-cap stocks as well as technology issues, so an increased beta over Stansky's version of Magellan isn't too much of a surprise. Nonetheless, Magellan's beta under Lange has continued to creep up, and its current beta of 1.22 suggests its moves will be about 20% greater than those of the S&P 500 Index. What's been disappointing, however, is that the fund hasn't compensated shareholders for the additional risk that comes with growth investing.

 Mutual Beacon  (TEBIX)
For many years Mutual Series' funds were, well, beacons of stability. But the betas of this fund and  Mutual Shares  (TESIX) have risen in the past decade. In mid-2004 its three-year beta hovered around 0.60; today it's around 0.92. That suggests more-moderate returns than the S&P 500 Index but is a meaningful increase. As is the case with Fairholme, the fund's financials stake, long a staple here, deserves part of the blame. The fund's increasing ventures overseas, while diversifying the portfolio some, have also introduced some volatility. (In the past several years, the fund's foreign stake has been bumping up against its 35% maximum allocation.) Lately, the fund has been buying more U.S. health-care names, which could bring the volatility and beta back down.

 TCW Dividend Focused  (TGIGX)
Investors likely expect less risk from funds that focus on dividend payers, and this fund used to fit that bill. But its beta has risen during the past 10 years, especially in two meaningful jumps: toward the end of 2005 and toward the end of 2008. Today its 1.14 beta is a far cry from its 0.80 beta of yesteryear. This dividend fund is different, though, in a couple of ways. First, its main goal is total return, which means it doesn't have the yield cushion that other dividend funds have. In addition, its relatively compact 56-name portfolio means greater issue risk than you see at most dividend funds.