To find managers that consistently gain more upside return than they do downside return, calculate managers’ capture ratio over one-, three-, five-, 10-, and 15-year periods. Here’s how you do it:
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 (upside capture ratio of 100 / downside capture ratio of 100 = capture ratio of 1.00) will most likely have a symmetrical correlation to the market. Where as, 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 to build capital more consistently, you should calculate capture ratio before you look at any other metric. To illustrate the advantage capture ratio can provide, let’s take a look at two hypothetical portfolios.
The first portfolio, also known as “The Usual Suspects” consists of six commonly held mutual funds - two balanced, one bond, 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. The hypothetical investment portfolio began at the beginning of the 2000 bear market with a $1,000,000 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, the portfolio grew the initial $1,000,000 investment to $1,094,107. It is important to note that the S&P 500 Total Index was down nearly 40 percent over the same period. The market bounced back from 2003 to 2007. During this time,“The Usual Suspects” improved from $1,362,586 to $2,057,187. However, in 2008, the portfolio declined 26.60% taking $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.
In an effort to find mutual funds that met the criteria of gaining more and losing less, a spreadsheet was used to log the upside and downside capture ratios for each fund. The capture ratio was then calculated for each fund 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 achieve a capture ratio of 1.00 or more over each period. In addition, some of the funds inconsistently produced a capture ratio above 1.00. 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.
Using capture ratio exclusively, a modified portfolio was created –“Capture Ratio Maximized.” “The Usual Suspects” 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 using funds in the same universe with capture ratios consistently higher than 1.00. The new “Capture Ratio Maximized” portfolio improved in multiple facets. Annualized rate of return increased from 6.76% to 7.68% and cumulative return increased from 121.62% to 146.21% percent. In addition, the portfolio’s worst down-market year, 2008, perks up from a negative return of 26.60% to negative 16.65%. The “Capture Ratio Maximized” portfolio may not generate as much upside return in good market years, but better downside capture ratio dynamics provided a larger capital base to start with in recovery periods.
From 2000 to 2002, the “Capture Ratio Maximized” portfolio grew from the initial $1,000,000 investment to $1,196,186. “The Usual Suspects” portfolio grew to $1,094,107. During the recovery period from 2003 to 2007, the portfolios ended with nearly the same capital balance, “The Usual Suspects” with $2,057,187 and “Capture Ratio Maximized” with $2,054,056. “The Capture Ratio Maximized” portfolio illustrates the potential loss protection benefits of performing capture ratio analysis by way of the market meltdown in 2008, ending the year 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 Usual Suspects.” This capital savings gives the “Capture Ratio Maximized” portfolio significant edge leading into the recovery years. At the end of 2011, the “Capture Ratio Maximized Portfolio” finished with $2,462,078 versus $2,216,199 for “The Usual Suspects.”
It is evident that reducing downside market capture can improve a portfolio’s dynamics greatly. Remember, this simplistic study focused solely on capture ratio to make investment decisions. Further due diligence could enhance these results even more drastically.