What's the Proper Beta? Financial Advisors and the "Two-beta Trap"

This article considers the common practice of providing equity mutual fund betas estimated with both a broad-based market index and a narrower Best Fit index, demonstrates that the two betas are not generally interchangeable, and specifies the circumstances under which the use of one or the other is more appropriate. Apparently, clients chaise their financial advisors to construct investment portfolios that will provide a return sufficient to achieve client financial goals, while minimizing the risk incurred to achieve that return. At a minimum, such requires the advisor to assemble a portfolio appropriate for the client's level of risk tolerance. Thus, advisors must assess security risk in order to construct portfolios appropriate for their clients. For over two decades, as of September 2003, investment advisors have understood that a key measure of portfolio risk is a security's beta coefficient, which measures the relationship between a security's returns and those of an index. Less well understood, however, is that the appropriate use of a beta coefficient is determined by how it is calculated, and the assumptions underlying the estimation process. Apparently, financial advisors must assess security risk in order to construct appropriate portfolios for their clients.