Jan 25

Managing Market Risk using Variable Beta Funds

Lonsec have a reasonable investment strategy paper released today (subscription required) suggesting one of the best ways of managing equity market risk is to use variable beta managers. A variable beta manager is a manager who has the ability to significantly change their exposure to the market depending on their view. So if a variable beta fund believes shares are undervalued they will fully invest into the sharemarket and if they believe overvalued they may increase their cash holdings or maybe increase their shorts (i.e. selling stocks in the hope they will falll in price before they buy them back).

To support their point, Lonsec say that they have added K2 Australian Absolute Return Fund to their model portfolio because, “K2 have a specific focus on downside risk in their portfolio by varying their market exposure within the fund. During a strong bull run, strategies such as K2 will keep their fund fully invested…then sell out of equities when they believe the risks are too great…”. Sounds great and K2’s overall track record is certainly one that many Australian fund managers would envy.

I’m skeptical of every fund so I conducted some in-depth performance analysis to understand K2’s performance drivers and most of the results certainly supported that they are a manager of skill. For example, since the end of 1999, K2 have outperformed the Australian sharemarket indices and achieved alpha of almost 5%pa whilst their market beta was a relatively low 0.66 (i.e. less risk than the market). It did have a small cap bias but my model showed that the market and small cap effect only explained around half of their performance with rest explained by other effects such as market timing…either way, great results for K2 since 1999.

Their relative performance since the end of the bull market (Oct 2007)¬† is excellent and this was totally explained by having low exposure to the market…beta less than 1 again plus very high alpha around 4%pa.

Where K2’s performance fell down was during the bull market from March 2003 to October 2007. Overall, they significantly underperformed the MSCI Australian Index by around 4,5%pa, but I guess it is difficult to complain when you receive 20%pa instead of the market’s 25%pa. My performance analysis showed that during this bull market K2 did not have the market exposure Lonsec claimed they would have (i.e. a beta close to 1) with a relatively low market beta of ~0.55 plus a reasonable exposure to small cap stocks. This low beta explains why they underperformed the market because during this time, K2 still were able to display skill with a strong alpha of 1% (after taking into small cap effects).

Anyway, in theory a variable beta fund could be a worthy addition to an investment portfolio if you are looking to outsource management of market exposure. I agree with Lonsec that K2 is an excellent fund for doing this job. The warning derived from my analysis is that, whilst variable beta funds (or a research houses) may tell you they will be fully exposed to sharemarkets during a bull market run, there’s always a chance they won’t hence they could significantly underperform the market during these times.


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  1. AFundie

    Did K2 underperform in all years 2003-07 by being low beta or was the low beta only in part of that period? I could understand the lower beta in say 2006 and especially 2007 as the PMs may have viewed the market as overvalued.

    1. michael

      The analysis I performed was from March 2003 to Oct 2007 and across the whole period K2’s beta was ~0.55 which is pretty low and not where you necessarily want your Aussie share manager to be. My analysis over this period when looking at Fama French factors also showed a significant small cap and value bias to their portfolio…so I’d say its a combination of being low beta and low value that has resulted in the underperformance…although risk adjusted they still come up trumps with annualised alpha of 1%.

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