Downside Capture Ratio

A Downside Capture Ratio is a mutual fund performance metric that calculates the percentage loss of an investment scheme compared to the returns of its benchmark index during a downtrend market scenario. A scheme is considered favorable if it has lost less than its benchmark in the bearish run.

It is a type of capture ratio that helps investors gauge the degree of risk associated with a fund when the market shows a dip and helps them devise the right investment strategy. A ratio below 100 is considered appropriate since it signifies that the scheme has lost less than its benchmark in a bear market trend.

• The downside capture ratio is a performance metric used to assess how much of a return a particular investment plan loses in a bear market compared to the lost returns of the relevant benchmark index.
• Understanding these ratios helps investors gauge fund performance in different market conditions, aiding informed investment decisions.
• An ideal ratio is below 100, indicating the investment scheme has lost less than its benchmark index when the market is down.
• Conversely, the upside capture ratio determines a fund’s potential to generate higher returns than its benchmark in favorable market conditions.

The downside capture ratio is a key measure during market downturns, reflecting performance relative to standard indices. This metric compares fund returns with its benchmark index to assess if the fund fares better or worse during a market dip.

An investment with a down-market capture ratio below 100 can potentially fare better than the index in a downtrend. Similarly, a ratio above 100 indicates the fund has experienced greater losses compared to the benchmark, suggesting higher risk. On the contrary, a ratio of 100 indicates neutral performance in a declining market, which seems unrealistic.

Some key considerations for effectively determining the downside capture ratio of mutual funds are as follows:

1. Choose a benchmark matching your fund type, like a debt index, instead of a stock one in the same category.
2. Simultaneously, the ratio should be evaluated considering the investment goals and tenure.
3. Also, the down-market ratios of funds facilitate the comparison of schemes within the same investment category.

This approach targets short-term investments as market downturns are brief, with long-term investments generally yielding good returns. Moreover, its relevance considerably depends upon the selection of an appropriate benchmark index. Focusing only on downside capture overlooks key aspects of a fund's performance for an investor to consider fully.

This ratio compares mutual fund/investment returns with benchmark/index during a bearish market, evaluated as:

Downside Capture Ratio = (Fund returns during bear runs/Benchmark returns) x 100

Thus, it indicates the degree of strength or weakness of a fund in a bear or downside market trend.

Professionals analyze down-market capture ratios for investment schemes to assess their performance against benchmark indices. Given below are some of such instances:

Example #1

Suppose in the stock market, an investor compares stock A and B's down-market capture ratios to the S&P 500 as the benchmark index. The ratio of stock A was 90%, and stock B was 105%. It signifies that stock A lost 10% less than the S&P 500, and stock B lost 5% more than the S&P 500. Due to his risk-conscious approach, he chooses to retain stock A for better returns, even during market downturns. However, he would sell off stock B, presuming its high-risk profile.

Example #2

If a stock drops 15% in 3 months and the benchmark index falls 16% in the same period, it suggests a bearish trend. Let us determine the downside capture ratio.

Solution:

Downside Capture Ratio = (fund returns during bear runs / benchmark returns) x 100 = (-15/-16) x 100 = 93.75%

Thus, the stock is said to have a lower loss of returns than the benchmark index, making it a favorable investment option.

Example #3

An article from Oct 11, 2023, highlights small-cap vulnerabilities in the rational market due to weaker businesses and increased external funding dependence. They can benefit from mild recessions with stable inflation and interest rates. One such fund is the Reinhart Genesis Fund.

With a 96% upside ratio and a 65% downside capture ratio, the Reinhart Genesis fund broadly captures the upside of the small-cap stock market. The fund, which focuses on durable companies, typically holds 35 to 45 stocks, according to manager Matthew Martinek. This boutique fund, with more concentrated portfolios than large firms, invests in teams of deep analysts covering numerous small stocks globally.

The downside and upside capture ratios are critical tools for investment decision-making. They are the two different stock market condition-specific mutual fund performance metrics that have the following dissimilarities:

This article has been a guide to Downside Capture Ratio and its meaning. We explain it with its formula, examples, & comparison with upside capture ratio. You may also find some useful articles here –

• Mutual Fund Theorem
• Risk Adjusted Return
• Semi-Deviation