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 new statistic called “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 you target higher rates of return, you may lose a significant amount of capital during unfavorable market periods. If you lose too much money, the markets may not recover enough to bail you out.
When investing, you should follow one simple rule. As long as I have capital, I will always be in great shape. Following this one rudimentary rule is easy. To achieve your primary goal, building a bigger capital base to pull you through retirement, you need to make sure you have capital. 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 should have 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 statistic, capture ratio, is currently not published widely. However, it is extremely easy to calculate using two statistics, upside capture ratio and downside capture ratio, published at Morningstar.com. Before we delve further into the concept of capture ratio as a standalone and how to use it, let’s gain a firmer grasp on the two numbers used to calculate it.
Upside and downside capture ratios for mutual funds appear under the “Ratings and Risk” tab for each individual mutual fund at Morningstar.com. These statistics, 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 fund's monthly return during months when the benchmark had a positive return and dividing it by the benchmark return during that same month. Downside capture ratios are calculated by taking the fund's monthly return during the periods of negative benchmark performance and 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 a fund has generally outperformed the benchmark during periods of positive returns for the benchmark. Meanwhile, a downside capture ratio of less than 100 indicates that a fund has lost lessthan its benchmark in periods when the benchmark has been in the red. Typically, all stock funds' upside and downside capture ratios are calculated versus the S&P 500, whereas bond and international funds' ratios are calculated relative to the Barclays CapitalU.S. Aggregate Bond Index and MSCI EAFE Index, respectively.
Here is an example of how upside and downside capture 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 that has an upside capture ratio greater than their downside capture ratio will tend tobuild capital more consistently over long periods.