Money Matters: What up/down capture ratio means to your portfolio

 Sharon L. Thornton, The Daily Record Newswire

Modern portfolio theory is a theory that attempts to show how an investor can maximize his/her portfolio’s expected return for any given amount of risk the investor is willing to undertake. Stated differently, it shows how an investor seeking a particular expected rate of return can minimize the amount of risk they need take to achieve that expected return.

The key to this is choosing the correct percentages of a variety of different assets. Different asset classes often change in value in different ways; that is, their returns are not perfectly correlated. In fact some asset classes show negative correlation meaning they react oppositely to each other and thus lower the variance of a portfolio’s return.

Modern portfolio theory has thus led to a complete change in the way investment portfolios are analyzed. Investors have gained sophistication and learned to use statistics such as alpha, beta, sharpe ratio, and standard deviation. However, there are other statistical measurements which are both easier to understand and demonstrate the potential risks and rewards associated with different investment managers.

Up-capture and down-capture ratios are two widely used statistics for measuring investment performance. Either one on their own is not effective in evaluating overall investment performance, but when combined present a valuable picture of a manager’s volatility in comparison to the appropriate benchmark.

Up-capture ratio compares a portfolio’s performance against its benchmark during periods where the benchmark’s performance is positive. Down-capture ratio compares the portfolio’s performance against the benchmark in periods where the performance is negative. A value of 100 percent means that the manager fully matches (or captures) the benchmark return during the period evaluated.

Values greater than 100 percent would mean that the manager captures performance greater or lesser than the benchmark (this is positive for up-capture and negative for down-capture). Should the value be less than 100 percent that means that the manager had less return on the upside or fell less than the index (benchmark) on the downside.

A low downside capture ratio is a definite positive for a manager, showing that the manager had a better performance than the benchmark when the benchmark was negative. This means that there is less of a hurdle to overcome from negative returns in a down market, and the manager can regain a previous high asset level much easier. By not losing as much when the benchmark declines, one has a easier time returning to a previous high value than if one lost as much (or more) when the benchmark declined.

In theory, this can help determine if a given manager is more aggressive or more defensive in nature than the chosen benchmark at various stages of the market cycle. This tool can be a useful aid in selecting an investment manager that is appropriate for the investment risk (especially on the downside) that an investor is willing to assume.

A manager that consistently outperforms the benchmark when it is positive and loses less than the benchmark in periods when the benchmark is negative, will outperform the index over the course of the business cycle. A low downside capture ratio also provides protection for an investor’s assets in times when markets are in decline.

The primary goal of investing is to build sufficient capital to fulfill your goals. As a result, many investors believe they have to shoot for the highest rate of return in order to build the largest 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 conditions.

Should you lose too much money, the markets may not recover enough to bail you out, at least not in a time frame that is meaningful to you. By minimizing losses during unfavorable market periods, it will take less time to recoup and start making money in favorable conditions. Minimizing losses when a benchmark is negative makes achieving positive long term returns much easier. A manager with higher than market gains in up markets but higher losses in down markets is less likely to meet your objectives.

Capture ratios can help you choose a manager that will build capital more consistently over longer periods of time. Remember that capture ratios are based on the rate of return achieved relative to the market. Instead of looking strictly at absolute returns or performance, as many investors do, look at how a manager does relative to the benchmark in both up and down markets.

A manager with a low downside capture ratio may be doing a tremendous job for you at the very time you are distressed by losing money. If your losses are less than those of the benchmark when the benchmark is negative, it will be easier for your returns to get back to previous levels.

Stop chasing the highest investment returns when markets are strong, and focus on both the upside and downside capture ratios. Knowing both and choosing a manager who has strong performance relative to the benchmark in both up and down markets, will greatly aid you in achieving your investment goals.


Sharon L. Thornton is senior director of investments for Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.