After a decade of significant market declines and an increasing amount of volatility, it is safe to assume that many investors would like to find the best-performing investment managers with the least amount of volatility. Today, if investing were compared to a roller coaster, it would be the scariest roller coaster that Great Adventure has to offer. Many people would be more comfortable with an investment experience more akin to the teacups at the county fair.
So how can you fine-tweak your investment portfolio to find investment managers that achieve good returns without participating too much in the downside during negative market periods? The answer may be easier to find than you think. A statistic called the “capture ratio” may be all you need to increase your odds of success.
The primary goal for most investors is to build a capital base with enough horsepower to pull them through retirement. As a result, many investors think they have to shoot for the highest rate of return in order to build the largest possible capital base. Investors fail to keep in mind that when they target higher rates of return, they may lose a significant amount of capital during unfavorable market periods. If they lose too much money, the markets may not recover enough to bail them out.
You should follow one simple rule: “As long as I have capital, I will always be in great shape.” If you do, you can achieve your primary goal of building a bigger capital base to pull you through retirement. And following this rudimentary rule is easy: By minimizing losses during unfavorable market periods, it will take you less time to start making money when markets turn favorable. As a result, you’ll enjoy a greater probability of increasing your capital base during good market periods. If you can repeat this theme over time, your portfolio will grow in value.
The capture ratio statistic is not currently published widely. But it is extremely easy to calculate using two other statistics: the upside capture and the downside capture ratios for funds published at Morningstar.com. Before we delve further into the concept and how to use it, let’s gain a firmer grasp of those two numbers.
The upside and downside capture ratios for mutual funds appear under the “Ratings and Risk” tab for each individual mutual fund at Morningstar.com. These two numbers offer a relatively straightforward way to evaluate a fund’s historical performance during both rallies and down markets. In short, the statistics show you whether a given fund has outperformed—gained more or lost less than—a broad market benchmark during periods of market strength and weakness, and if so, by how much. When used in conjunction with other risk measures, upside/downside capture ratios can be a handy tool for monitoring your holdings’ performance and conducting due diligence on possible additions to your portfolio.
Upside capture ratios for funds are calculated by taking the funds’ monthly return and dividing it by the return of the benchmark during months the benchmark is positive. Downside capture ratios are calculated by taking the fund’s monthly return during the periods of negative benchmark performance and also dividing it by the benchmark return. Morningstar.com displays the upside and downside capture ratios over one-, three-, five-, 10- and 15-year periods.
An upside capture ratio over 100 indicates that a fund has generally outperformed the benchmark during periods when the latter has turned in positive returns. Meanwhile, a downside capture ratio of less than 100 indicates that the fund lost less than the benchmark during periods the benchmark was in the red. Typically, all stock funds’ upside and downside capture ratios are calculated against the S&P 500, whereas bond and international funds’ ratios are calculated relative to the Barclays Capital U.S. Aggregate Bond Index and the MSCI EAFE Index, respectively.1
Here is an example of how the ratios work. If a mutual fund has an upside capture ratio of 100, then the mutual fund would achieve approximately 100% of the market’s upside. This means that when the market is up 10%, the fund would most likely be up 10% as well. On the other hand, if a mutual fund has a downside capture ratio of 70, then the fund would most likely capture 70% of the downside. As a result, if the market is down 10%, then the fund should have a negative return of approximately 7%. An investment manager with an upside ratio greater than its downside ratio will tend to build capital more consistently over long periods.
These two metrics together allow us to find the capture ratio. To find managers with the greater upside capture ratio, investors can calculate managers’ capture ratio over one-, three-, five-, 10-, and 15-year periods:
Upside Capture Ratio / Downside Capture Ratio = CAPTURE RATIO
A capture ratio of more than 1.00 indicates that a fund will generally outperform its benchmark index. The higher the number, the better off you will be. For example, a manager that has a capture ratio of 1.00 (found by taking the upside capture ratio of 100 divided by a downside capture ratio of 100) will most likely show a direct correlation with the market. But the manager who has an upside capture ratio of 100 and a downside capture ratio of 50 (100 / 50 = 2.00) will experience more upside with significantly less downside, thereby building capital more consistently.
If you want to engineer a portfolio that will help you build capital more consistently, you should calculate the capture ratio before you look at any other metric. To show the capture ratio’s advantages, let’s take a look at two hypothetical portfolios.
The first, also known as “The Usual Suspects,” consists of six commonly held mutual funds—two balanced funds, one bond fund, one dividend-focused stock fund, a domestic growth fund and an EAFE growth fund. Each mutual fund is equally weighted in the portfolio’s allocation. We start this hypothetical investment portfolio at the beginning of the 2000 bear market with a $1 million initial investment.
Since 2000, the usual suspects portfolio performed quite well, posting a 6.76% annualized rate of return over the trailing 12-year period of the analysis, while the S&P 500 Total Return Index struggled to post a small positive return. During the bear market of 2000 to 2002, our usual suspects portfolio grew from an initial $1 million investment to $1,094,107. It is important to note that the S&P 500 Total Return Index was down nearly 40% over the same period. The market bounced back from 2003 to 2007. During this time, our hypothetical portfolio grew from $1,362,586 to $2,057,187. However, in 2008, the portfolio declined 26.60%, shrinking from $2,057,187 to $1,509,936, a loss of $547,251. While the portfolio lost less than the market index, losses of 20% or more tend to cause investors to abandon their investment plan. The goal is to build a portfolio with components that improve loss protection without giving up much of the upside.2
To find mutual funds that gained more and lost less, we can use a spreadsheet to log the upside and downside capture ratios for each fund. These capture ratios are then calculated over the three-, five-, 10- and 15-year periods. Many of the usual suspects met the criteria of achieving a capture ratio of 1.00 or more. However, there were several funds that did not do it over each period. For some funds, the performance was inconsistent. Several funds captured more downside than upside—some over multiple periods—and a portfolio that masters the art of capturing losses greater than the market is unwanted.
The second hypothetical portfolio modifies the first one by trying to maximize the capture ratio. Those funds that did not achieve a capture ratio of 1.00 or higher over multiple periods were eliminated from the allocation. The allocation was then updated with funds in the same universe that had capture ratios consistently higher than 1.00. The new “maximized capture ratio” portfolio shows improvement in different ways. The annualized rate of return increases from 6.76% to 7.68% and the cumulative return increases from 121.62% to 146.21%. In addition, the portfolio’s worst down-market year, 2008, perks up from a negative return of 26.60% to a negative return of 16.65%. This portfolio may not generate as much upside return in good market years, but better downside capture ratio dynamics offer a larger capital base to start with in recovery periods.
From 2000 to 2002, the maximized capture ratio portfolio grows from the initial $1 million investment to $1,196,186. The usual suspects portfolio grows to only $1,094,107. During the recovery period from 2003 to 2007, the portfolios end with nearly the same capital balance, the usual suspects with $2,057,187 and the maximized capture ratio portfolio with $2,054,056. The latter illustrates the potential loss protection benefits of performing capture ratio analysis amid a market meltdown; it ends 2008 with $1,712,091, a loss of 16.65%. The decreased participation in a down market yields a capital savings of $205,286 over the other portfolio. These savings would have given the maximized capture ratio portfolio a significant edge leading into the recovery years. At the end of 2011, the portfolio would have finished with $2,462,078, while the usual suspects portfolio would have finished with $2,216,199.3
It is evident that reducing downside market capture can improve a portfolio’s dynamics greatly. Remember, this simplistic study focuses solely on capture ratio to make investment decisions. Further due diligence could enhance these results even more drastically.
The capture ratio can help you create a portfolio that builds capital more consistently over long periods of time. Keep in mind that capture ratio is based on the rate of return achieved relative to the market. So it is one of the only statistics that is outcome-oriented and doesn’t solely consider the return, the way most investors do. That means investors must resist the urge to employ the manager with the highest return and focus on building a portfolio that will achieve their investment goals.
1 Upside & Downside Capture Ratio, Morningstar Investing Glossary, 2012, Morningstar, Inc., October 5, 2012. http://news.morningstar.com/articlenet/article.aspx?id=374386
2 Hypothetical Portfolio Illustration, Morningstar Principia, 2012, Morningstar, Inc.,
March 27, 2012
3 Hypothetical Portfolio Illustration, Morningstar Principia, 2012, Morningstar, Inc.,
March 27, 2012
Matt Schreiber is vice president of investments at WBI Investments and a senior member of the firm’s investment committee. WBI Investments manages $1.4 billion in absolute return strategies for income and growth.