What effect does increased correlation between a fund's returns and market returns have on beta?

Increased correlation between a fund's returns and market returns directly leads to an increase in beta. Beta is a measure of a fund's sensitivity to market movements, or how much the fund's returns change in relation to changes in the overall market. When the correlation between the fund’s returns and the market increases, it means that the fund's returns are moving more closely in synchrony with market movements.

As correlation approaches one (meaning the fund's performance is almost fully aligned with the market's performance), the computed beta—as part of the Capital Asset Pricing Model (CAPM)—increases as well. A higher beta indicates greater volatility compared to the market, which suggests that the fund will experience bigger swings in returns, reflecting its higher risk and sensitivity to market fluctuations.

This understanding is key for investors looking to assess risk and return, especially in the context of building a diversified portfolio. A fund with a high beta might offer the potential for higher returns, but also comes with a greater risk of loss during market downturns.