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Funds that can neutralize clients’ conservative tendencies

Clients’ financial and economic decisions take many forms. And whether their choices are methodically planned over time, or subtly behavior-driven, there is always a psychology behind them.

One of the most challenging obstacles for planners is what psychologists call loss aversion. And while many advisers might not know the official term, they certainly know the tendency: clients prefer avoiding losses even more than they want to acquire gains. Also called behavioral finance loss aversion, the tendency can hurt investment strategy.

“One of the biggest challenges is educating investors about the way volatility is impacting their behavior and how their behavior is impacting their portfolio returns,” says Isaac Braley, president and investment committee member at BTS Asset Management in Lexington, Massachusetts. “Studies show that the average investor only earns about 2.5% a year due to behavioral decision-making.”

But there’s one possible solution. By using funds with favorable historic capture ratios, an adviser can redirect and minimize some losses. At the same time, charting the capture ratio statistic over time is one way to discern a fund manager’s performance. Funds' upside and downside ratios are posted on Morningstar's website.

When comparing funds, a ratio under 100 in a declining market indicates that the manager outperformed the market. In a rising market, a ratio over 100 signifies that the manager outperformed the market. The capture ratio is determined by a fund’s performance compared to relevant benchmarks, in up and down markets.

For example, Invesco Diversified Dividend Fund has favorable capture ratios, according to Vince Barbera, managing partner at Newbridge Wealth Management in Berwyn, Pennsylvania. It has a 10-year downside capture ratio below 83% and an upside capture ratio over 90%. This fund has held losses to about 83% of the broad market’s drop during downturns and returned more than 90% of gains in upturns.

Ideally, there will be a positive difference between the upside success and downside protection. Such conservative investment approaches might be important to risk-averse investors, says BTS’s Braley.

Braley says investors are far more conservative than they believe.

“Trying to change primal behavior can be very difficult,” he says. One way advisers might encourage change, he suggests, is to recommend investments that will elicit neither fear nor euphoria.

“That could be a portfolio with a more modest return and a better sequence of returns,” Braley says. “Maybe we should not be talking to investors about 7% or 8% or 9% returns, but rather how to potentially achieve something better than the historical 2.5% return. That’s something advisers can control — setting the right portfolio expectations.”

When looking at downside capture ratios for fund selection, it’s important to use a long time period, according to Russ Kinnel, director of manager research at Morningstar.

Within selected categories, these are the leading large funds (at least $1 billion in assets) in 10-year downside capture ratio.

Fund 10-Year Downside Capture Ratio Annualized Total Return
U.S. Large Blend
First Eagle U.S. Value 63.708 7.003
GMO Quality III 71.656 7.994
Vanguard Dividend Growth 72.463 8.755
BBH Core Select 74.57 8.993
Category average 103.018 6.608
Foreign Large Blend
First Eagle Overseas 49.377 5.75
MFS International Value 65.158 6.29
Artisan International Value 69.233 6.859
PIMCO StocksPLUS International (USD-Hedged) 77.797 5.318
Category average 96.762 1.623
Intermediate-Term Bond
JPMorgan Mortgage-Backed 26.986 5.231
TCW Total Return Bond 30.142 6.989
Loomis Sayles Secruitized Asset 42.371 6.255
Fidelity Mortgage Securities 51.617 3.971
Category average 106.517 4.604
Data through 8/16
Source: Morningstar

“If you are looking at a U.S. stock fund, downside capture for the past three or five years only tells you how the fund fared in some rather modest downturns,” he says. “You need 10-year downside capture to get the last bear market.”

With that caution in mind, is a trailing five-year downside capture helpful? Advisers likely need longer-term numbers.

“We start by looking at the length of the current management team’s tenure,” says Peter Somich, an investment analyst in the Boston office of Modera Wealth Management, “to see if the capture ratios have changed over time. We also will isolate performance during market volatility: the financial crisis, the 2011 S&P downgrade of U.S. credit, etc.”

Barbera says he likes to see an entire market cycle. A 10-year capture ratio might be more meaningful than one covering five years that might include the chaos of late 2008.

For Barbera, capture ratios are important when choosing funds. “There has to be a balance,” he says, “but if I feel that we are at the end of a cycle, then downside is more important. In the high-stock-valuation environment in which we find ourselves today, that dictates a move to a more downside-protected portfolio. When stocks become cheaper and we move to a risk-on position, favorable downside capture is still important, but less so.”

Beyond 10-year numbers, Kinnel says there are other factors to consider. “One is the benchmark used. 0ften, it’s a broad index, which is fine if the fund in question is a large-cap fund or a high-quality bond fund. For other types of funds, you would be better off with downside capture using a more specific benchmark.”

To use capture ratios effectively, Kinnel continues, advisers should check the upside capture ratio to get a sense of the risk/reward profile. “There is a great deal of demand for low-risk investments. However, funds with attractive downside capture often have low upside capture as well.”

Barbera looks for favorable downside capture with acceptable upside. “More than likely,” he says, “the upside will be less than 100%” if the downside is appealing.

Sacrificing potential gains for possible downside shelter appeals to conservative investors because “intellectually, they understand that you have to give up upside for protection,” Barbera says.

Somich uses upside and downside capture ratios to help analyze potential investment products. “Where upside and downside capture come into play most for us,” he says, “is at the product diligence steps. For instance, if an active manager emphasizes capital preservation over aggressive growth, we expect to see downside capture under 100.”

These ratios can allow advisers to compare the risk-adjusted returns of similar options. “If two investments have roughly the same upside capture,” Somich says, “but one has a significantly better downside number, then it could be a differentiator between the two. (Capture ratios) provide another point to reference in our decision making.”

“Upside and downside capture ratios are important, but only if a client can stand it,” says Jerry Verseput, CFP, president and principal adviser at Veripax Financial Management in Folsom, California. “Capture ratios are statistical measurements, and statistics require a large sample size in order for the characteristics to show themselves. For a fund that has an asymmetrical capture ratio (higher upside capture than downside capture), it must be given a full market cycle to fully realize the benefit.”

Unfortunately, Verseput says, “very few investors and even advisers have the patience to allow the statistics to play themselves out during a bull-market phase.”

A key to using capture ratios might be proper framing by advisers.

“I’m not overly concerned if some of the ETFs or funds I use have low upside,” says Steve Stanganelli, principal at Clear View Wealth Advisors in Amesbury, Massachusetts. “The total portfolio may have a higher upside. I’m not a home-run hitter. I tell clients that what matters is not whether a particular fund, ETF or portfolio is a grand slam. Slow and steady wins, and investors win by not losing.”

Stanganelli relies on downside capture and other tools to help protect clients on the downside.

“If an aggressive portfolio goes way up but then crashes, a client might bail out of the market,” Stanganelli notes. “Then the client won’t be positioned to ride the wave up again. However, if the portfolio exhibits lower volatility and doesn’t decline as much as everything else, clients may be less inclined to panic: They’ll stay the course and, like the tortoise, end up winning.”

An adviser who agrees that behavioral issues might affect efficient use of capture ratios is Richard Brink, a managing director in the alternatives and multi-asset group at investment management and research firm AllianceBernstein.

“Many clients won’t be able to stand getting, say, only 50% of the market’s upside,” he says. “Waiting for downside protection could be difficult enough if the market is returning 9% a year and clients see a 4.5% return. It’s even tougher in times like the past several years, when the market has returned 16% to 18% a year and clients gave up 800 to 900 basis points of return, with such a defensive stance. Investor discontent can occur.”

When Brink discusses the use of capture ratios with advisers, he encounters fears of “client risk” – people going elsewhere if results lag the headline numbers. “To get the full benefit of this capture-ratio strategy, investors must stay in for the entire market. That may not happen if they leave one adviser to go for higher returns.”

Brink suggests several ways to overcome this behavioral reaction. One is to walk clients through forecasting engines and Monte Carlo simulations. “With this type of portfolio, clients may well see an increasing probability of success towards meeting their goals,” he says.

Another approach is for advisers to meet a client’s mindset up front “to get a ‘behavioral benchmark’ — an idea of their tolerance for below-market returns,” Brink says.

Brink also mentions the tactic of presenting the capture ratio approach as portfolio insurance.

“For advisers, this will mean ... telling clients that the conversation is not about an actual insurance policy,” he says. “Advisers can compare the difference between the market's gain and the strategy's upside capture—for example, 50% of the full-market gain—to an insurance premium paid for sacrificed upside potential. Then advisers can position the historic downside capture of, say, 20% as a deductible: Clients might have a 20% loss before this ‘policy’ kicks in to protect the downside.”

Many people are familiar with insuring against potential damages, Brink says, so the insurance analogy can resonate with clients after adequate disclosure.

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