Capture Ratio

A capture ratio refers to a statistical metric that evaluates an investment or mutual fund scheme's performance against its benchmark index during the specific market volatility phases over the period. Thus, it gauges a fund manager's efficiency in booking high returns during up-market and mitigating risk amidst the down-market scenario.

Traders, investors, and market analysts often use the upside and downside capture ratios to determine the quality of an investment scheme, such as a mutual fund, and its outperformance or underperformance potential during a bullish or bearish market trend. Thus, it facilitates the market participants in investment decision-making and risk management in the financial markets.

A capture ratio is a stock performance metric that provides a snapshot of the relative performance of a fund manager when compared to the returns of its benchmark index for a certain period during the market rally or slump. It analyzes both upside and downside capture ratios in a percentage value of 100. In other words, the upside ratio serves as a measure to evaluate a fund manager's efficiency in allocating funds in a particular asset class, such that it provides higher returns than the market during the bullish trend. A downside ratio assesses the fund manager's intelligence in mitigating losses while not allowing the portfolio to fall below the benchmark index during a bearish market movement.

However, investors most often employ an overall ratio to interpret the fund manager's comprehensive performance in both bull and bear market trends. The idea is to invest in schemes that offer favorable returns when the market is moving upwards and efficiently limit the losses when the market falls. Thus, investors often seek funds that have high up-capture and low down-capture values to achieve the desired investment goals.

The financial market volatility can either be a market rally or a slump. Based on these fluctuations, this ratio can be of the following two kinds:

1. Upside Capture Ratio: The up-capture ratio determines the fund manager's ability to outperform the market during a bullish trend or market rally. Investors often look out for schemes that provide relative returns in the up-market scenario.
2. Downside Capture Ratio: The down capture ratio analyzes if the fund manager's strategy has resulted in the underperformance of a particular investment scheme or mutual fund during the market slump, bear movement, or crash. Thus, it helps investors identify investments that provide risk-adjusted returns during down market conditions.

This ratio serves as a crucial measure to identify the potential of a fund manager to generate relative or risk-adjusted returns when compared to that of the benchmark indices. The basic steps involved in the evaluation of upside and downside capture ratios include the following:

1. Emphasize the investor's objective, whether it is return maximization during a market rally or risk mitigation at the time of a market downtrend or crash.

2. Collect relevant historical data on the investment returns for 1, 3, 5, 10, or 15 years of a particular mutual fund and its benchmark index for the same period.

3. Find the average of the fund manager's return for the selected timeframe. Using historical data, also determine the average return of the benchmark period for the same period.

4. Now, evaluate the up capture ratio using the formula: 

Upside Capture Ratio = (Fund Manager's Returns During Up-Market / Benchmark Index Returns) * 100.

5. Also, compute the down capture ratio through the equation: 

Downside Capture Ratio = (Fund Manager's Returns During Down-Market / Benchmark Index Returns) * 100.

6. Most investors, traders, and market analysts use the rolling or overall capture ratio to gauge the comprehensive performance of the fund in both up and down market movements. Thus,

Capture ratio = Upside Capture Ratio / Downside Capture Ratio

7. Finally, interpret the results as follows:

• If the upside capture ratio is more than 100, then the fund manager is believed to outperform the market. A ratio of less than 100 shows that the fund has not generated competitive returns compared to its benchmark during the market rally.
• A lower than 100 downside capture ratio shows that the fund manager has effectively managed to keep the mutual fund losses lower than its benchmark index. Simultaneously, a value higher than 100 signifies that the respective investment scheme holds higher risk during the market slump.
• Indeed, an overall market ratio above 1, is always considered favorable both in market upswing and downtrend scenarios. It represents that the fund's upside performance can effectively cover its downside losses or performance in the long run.

The fund managers work hard to design investment portfolios or schemes that offer higher than the average market returns while not exposing the invested money to high risk. These ratios, thus, help to gauge their efficiency in this context; let us see how:

Example #1

Suppose an investor, Mr. Danny, has two potential investment options, i.e., large-cap equity funds A and B. Now, Mr. Danny's investment horizon is just 1 year, and he uses the S&P 500 index as the benchmark index for comparing the performance of these potential investment schemes. Also, his investment objective is to make a relatively high return and exit the position. As per the historical data, the S&P 500 index generated 24.23% returns in 2023 during the market rally. Also, fund A and B's returns were 25.01% and 24.00%, respectively, for this period. Determine a feasible investment option.

Solution:

Fund A:

Upside Capture Ratio = (Fund Manager's Returns During Up-Market / Benchmark Index Returns) * 100 = (25.01 / 24.23) * 100 = 103.22

Fund B:

Upside Capture Ratio = (Fund Manager's Returns During Up-Market / Benchmark Index Returns) * 100 = (24 / 24.23) * 100 = 99.05

Now, in this case, Fund A is generating slightly better returns than the S&P 500 index and Fund B. However, it doesn't guarantee that it will hold less risk during the falling market conditions. Therefore, Mr. Danny needs to evaluate the other perspectives before making a decision.

Example #2

Some of the actively managed US equity funds have consistently outperformed their benchmarks, offering investors attractive returns with a balanced approach to capturing market gains while minimizing losses. Given below is a list of top-performing actively managed US equity funds over the past three years, along with their key metrics:

1. Artisan US Value Equity: Over the last three years, this fund has delivered a robust performance of 46.45%, outpacing its benchmark. It boasts an impressive upside ratio of 131% and a downside ratio of 103%. Some of its key holdings include Meta, Alphabet, and US Bancorp.
2. Smead US Value: With a 41.93% return over three years, this fund has demonstrated resilience and outperformance. Its upside ratio stands at 123%, while the downside ratio is 102%. Its prominent investments include Lennar Corp, DR Horton, and Occidental Petroleum Corp.
3. Ossiam Shiller Barclays Cape US Sector Value: This fund has yielded 38.33% over three years, aligning with its value-oriented strategy. It boasts an upside ratio of 120% and a downside ratio of 100%. Its top holdings comprise Meta, Amazon, and Alphabet.
4. Allianz Choice Best Styles US: This fund has achieved a commendable return of 37.51% in the past three years, with an upside ratio of 118% and a downside ratio of 100%. It maintains significant positions in Microsoft, Apple, and Amazon.
5. Comgest Growth America: This fund has delivered a robust 42.28% return over three years, showcasing its focus on growth-oriented investments. Its upside capture ratio is 113%, while the downside capture ratio is 107%. Its principal holdings include Microsoft, Eli Lilly, and Oracle.

It is essential to remember specific key points while employing the upside and downside capture ratios for mutual fund selection and informed decision-making. These are:

1. A fund that has a favorable up capture ratio tends to underperform during the market slump, and the ones that perform well during the bear market condition couldn't outperform its benchmark index during the market rally.
2. The timeframe for which this ratio is determined should align with the period ascertained for achieving a specific investment goal, whether it is 1, 3, 5, 10, or 15 years.
3. A ratio of 100 or nearly equal to 100 signifies that the fund behaves similarly to its benchmark index during market volatility, thus generating positive returns when the market is up and losing value in a down market condition.
4. However, a negative upside or downside capture ratio represents that a particular fund's performance was opposite to its benchmark index. Suppose the benchmark index provides positive returns, but the respective fund has a history of declining returns during the same period, or vice-versa.
5. It is essential to measure a fund's performance against its respective benchmark index, which belongs to the same asset class since comparing apples and oranges is unreasonable.
6. Likewise, it is crucial to compare these ratios of two or more mutual funds for the same period since the timeframe plays a critical role in shaping investment returns.