Market risk is a part of total risk, but measures only the sensitivity of the fund to movements in the general market. This is valuable information for the individual investor—particularly when combined with use of the total risk and category risk rank measures—to judge how a mutual fund will perform in different market situations. The market risk measure used for common stock funds is beta; for bond funds, average maturity can be used.
Beta is a measure of the relative volatility inherent in a mutual fund investment. This volatility is compared to some measure of the market such as Standard & Poor's index of 500 common stocks. The market's beta is always 1.0 by definition, and a money market fund's beta is always 0. If you hold a mutual fund with a beta of 1.0, it will move, on average, in tandem with the market. If the market is up 10%, the fund will be up, on average, 10%, and if the market drops 10%, the fund will drop, on average, 10%. A mutual fund with a beta of 1.5 is 50% more volatile than the market: If the market is up 10%, the fund will be up, on average, 50% more, or 15%; conversely, if the market is down 10%, the fund, on average, will be down 15%. A negative beta, a rare occurrence, implies that the mutual fund moves in the opposite direction of the market's movement.
The higher the fund's beta, the greater the volatility of the investment in the fund and the less appropriate the fund would be for shorter holding periods or to meet liquidity needs. Remember that beta is a relative measure: A low beta only implies that the fund's movement is not volatile relative to the market. Its return, however, may be quite variable, resulting in high total risk. For instance, industry-specific sector fund moves may not be related to market volatility, but changes in the industry may cause these funds' returns to fluctuate widely. For a well-diversified stock fund, beta is a very useful measure of risk, but for concentrated funds, beta only captures a portion of the variability that the fund may experience. Betas for certain sector funds, for example, can be very misleading. Sector funds often have relatively low betas, but these funds are extremely volatile. In addition, the betas of sector funds sometimes change significantly from year to year.
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