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How Mutual fund managers tweak their porfolio in a market correction !?

What is Beta ?

Beta is a measure of risk of an asset or a portfolio. It refers to how risky the asset/portfolio is with respect to the market.

Example :

If the beta of a stock is 0.7, that means that every time the market falls by 1%, the stock will fall by only 0.7%.

Put yourself in the shoes of a fund manager

Imagine you have a holding in a stock which has a beta of 1.5. When the market falls by 1 %, your stock will fall by 1.5%.

No one would like that. So if you suspect the market is correcting, you will look to sell your holding and buy at a lower price right ?

This is not something mutual fund managers can do.

Why Mutual fund managers can't do the obvious ?

Mutual funds managers can't offload their positions due to the following 2 reasons :

  • Holdings of mutual funds is large and if they offload their positions at the same time, the stock price will crash and they will get less price.

  • Mutual funds have a mandate of cash they can hold, which in most cases is not more than 5%. So they have to remain invested.

What they do instead ?

They implement a strategy called Beta Risk Management.

When the fund manager suspects that the market is ready for a correction, they tend to reduce the beta of their portfolio. This can be done through increasing allocation in certain sectors or stocks which have a Beta of less than 1.

Strategies for Beta Risk Management

1. Sector Diversification

Investing in a single industry or sector can expose your portfolio to sector-specific risks. By diversifying across various sectors such as technology, healthcare, finance, and consumer goods, you can reduce the impact of any single sector's underperformance. This strategy helps protect your portfolio from industry-specific downturns.

2. Asset Class Diversification

In addition to sector diversification, it is essential to diversify across different asset classes, including stocks, bonds, real estate, commodities, and cash equivalents. Different asset classes have varying risk-return profiles, and by diversifying, you can minimize the impact of poor performance in a specific asset class.

3. Geographic Diversification

Geographic diversification involves investing in securities from different countries and regions. Economic conditions, political stability, and market trends can vary significantly across regions. By spreading your investments globally, you can reduce the risk associated with any single country or region's economic downturn.

4. The Role of Index Funds and ETFs

Index funds and exchange-traded funds (ETFs) offer investors a convenient way to achieve diversification. These funds pool money from multiple investors to invest in a broad range of securities, usually tracking a specific index. By investing in index funds or ETFs, you can gain exposure to multiple stocks or assets within a single investment.

5. Rebalancing Your Portfolio

Regularly reviewing and rebalancing your portfolio is crucial for maintaining effective diversification. Over time, the performance of different investments may vary, causing your asset allocation to deviate from the desired levels. By rebalancing, you can sell overperforming assets and buy underperforming ones, bringing your portfolio back in line with your desired asset allocation.

How it affects their returns ?

The returns of a fund manager is always benchmarked to that of the market. So if in a particular time period, the market has given -10% returns, and the fund manager, through beta risk management, has managed to reduce the losses of his portfolio to 7%, he/she has outperformed the market.

That to me is a job done.


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