Bear-beating: coming soon to a marketplace near you?

Morgan Stanley, towards the end of last month, went on record saying that it expects a ‘sharp correction’ of 10-20% in equity markets, and this must have given investors food for thought. And when a chairman of one of the biggest investment banks in London was reported anonymously in The Times (24 July) as having moved all of his, his wife’s and their pensions’ money out of equities, investors would surely have been running to re-assess their portfolios. Well, now the widely expected market wobbles are upon us, and people are seeking out protective positions.

One of the defensive measures available to fund managers in a market downturn is to shift their portfolios towards a lower Beta position. Beta, we should recall, is the measure of how much a fund’s return changes when its benchmark moves up, or down, by one point. In a bear market, for every fall of one point in a benchmark or index, it is clearly advantageous to have a portfolio that does not follow the benchmark down at the same rate: the lower the Beta the better.

Using Financial Express’s Analytics, we can examine the behaviour of a selection of equity funds in the last bear market of 2000-2003, and see how their respective strategies worked out in the conditions over that time. These are taken from the IMA’s UK All Companies sector, and our first table shows funds with the five highest and five lowest Betas over the period April 2000-April 2003, along with their sector.

Total return from 01 Apr 2000 to 01 Apr 2003

Source: Financial Express Analytics

We can see here the polarity that divides the Beta positions taken and, with the exception of Neptune’s fund, the closely similar measures that the funds adopt within their separate ranges. Theoretically, market conditions over this period will have favoured those funds with a Beta of less than 1.0, and Neptune’s UK Equity most of all. At the other end of the scale, the finger points towards SocGen’s fund as the big loser, since for every one-point drop in the benchmark it was losing 1.30. But what really stands out here is the Manek fund. Its weak R² correlation to the sector means that we cannot place too much emphasis on the substantially negative Alpha and Information Ratios; although their scale and the indication that the manager has been deviating significantly from the benchmark’s population could be a sign that things may not have gone well. In order for us to see how these measures translate into performance, it is time for our next table.

Total return, bid-to-bid performance from 01 Apr 2000 to 01 Apr 2003

Source: Financial Express Analytics

It is the case that over this period, out of 171 funds in the sector, only three made a positive return, and even then these were more symbolic in nature than a cause for celebration. They do not figure in our study because their Beta positioning was broadly neutral. Other analytical measures that we can attribute their relative success within a hostile environment to winning stockpicking decisions that are rarely predictable. For our present purposes, let us return to the Beta-selected funds.

The outcomes in our selection are representative of the upper and lower reaches of the spectrum, and it is possible to see how strategy has affected the funds’ fortunes. Manek’s high Beta ensured that it would be move disproportionately downwards relative to the markets. The other negative indicators have played out as well, and leave the fund at the bottom of the table for the whole sector.

The noticeably low Beta of Neptune’s fund has served it well, placing it at the top of our selection. In conditions where the question of loss is not ‘whether’, but ‘how much’, the fund has performed appreciably better than many of its stablemates. If we look at the returns, then, it is the high Beta funds which have suffered, while the lower Betas both beat the benchmark and mitigate the losses that could have arisen.

What can this tell investors about conditions today, though?

Firstly, there are as many industry commentators saying that we are sliding into a bear market as there are who insist that this is a patch of sentiment-driven volatility, or a manageable correction, and that all the fundamentals are still in good shape. Investors and their advisers must take their individual views. But if we are heading towards a downturn, it would be helpful to identify the funds in this sector which have already positioned their Betas to meet it. This is where we post our final table.

Total return, 31 Jul 2006 to 31 Jul 2007 (risk free rate at 3.5%)

Name	Crown Rating	Beta	r 2	Sharpe	Volatility	Return 1yr
Invesco Perpetual Fund Mgrs - UK Opportunities		0.85	0.88	0.89	6.21	11.03
Jupiter UT Mgrs - Undervalued Assets		0.87	0.89	1.88	6.25	15.69
Soc Generale Investment Funds - UK Growth		0.92	0.92	1.31	6.52	12.84
UT UK All Companies Retail		1.00	1.00	1.48	6.82	14.08
Virgin Money - UK Index Tracking		0.91	0.88	1.39	6.63	11.48

Source: Financial Express Analytics

Our criteria for pointing up these four funds are three-fold. Initially, we only wanted funds with reasonably good R² correlations to the sector, so that we could place some reliance on other measurements. Next was to identify those whose Betas were usefully lower than the sector average. By definition, such funds would not have taken full advantage of the bull run and, indeed, their returns have been eclipsed over that period by those of some of their peers. But this is not the point – their current positioning is. Our third criterion was the funds’ Crown Ratings. At the highest level of three Crowns, this is a quantified indication over time of a fund’s performance, set in the context of both the volatility and the consistency of its returns. So ultimately, for investors who see the a prolonged period of turmoil and a downward turn in equity markets, these kinds of funds, with their lower sensitivity to benchmark falls and volatility, could be the ones to consider further.