A tool little noticed by investors can help you determine which investment style works in which market

 

Rob Isbitts writes a monthly column using Morningstar data to look at market trends.

 

When you come right down to it, there are really only a two things that determine how your client’s portfolio performs. One is the skill of the manager, whether that manager is you, a mutual fund or separate account firm you outsource to, or a combination. In our industry, we use the “Alpha” statistic to measure that level of skill. I often describe Alpha as the return you would expect to achieve if the market broke even. That is, when the market gives you lemons, how much lemonade can your manager squeeze out.

 

The other key factor in determining performance is the market itself. In most cases, I’d expect the “market” to be the S&P 500 Index, since both investors and advisors seem obsessed with that poorly-constructed, top-heavy, over-hyped benchmark (was that opinion strong enough for ya?). To the investor and their advisor, the market’s movements are not something that can be controlled. What can be actively managed is how volatile their portfolio is relative to the market. This is commonly known as “Beta” and it is measured as the portion of the market’s volatility that is experienced by the investment.

 

Alpha and Beta tell us a lot, but they also lead us to an even more useful measure of performance and manager acumen, which allows you and your client to better understand the range of possibilities they are bound to experience in different types of market environments. That is what we call “Capture Ratio,” and that special topic is what we’ll focus on here.

 

Capturing winners

 

Capture Ratio is a simple and valuable tool to evaluate the past performance of an investment and assess its potential role (if any) in one’s portfolio. Yet I don’t see much of an effort to put this valuable information in the hands of the investment public. Since Morningstar calculates this information for mutual fund category averages, I am able to share some notable points here. First, an explanation of Capture Ratio, excerpted from my 2010 book, “The Flexible Investing Playbook” (published by John Wiley & Sons):

 

Capture ratio is a statistic that tells you how much of the market’s move you have experienced. The “market” can be any index you can plug into the analytical software, but since the S&P 500 stock index is Morningstar’s standard stock market benchmark, we’ll use that example for now.
If for every 10% up move in the market your portfolio grew by 8%, your capture ratio is 80%. Capture ratio is often expressed as a decimal, so an 80% capture ratio might show up on a research report as “0.80.” Since we are talking about a time period when the market went up, we call this an up capture ratio, the portion of the up market that you capture. It works the same way on the downside. If the market went down 10%, and your portfolio went down 6%, you would have a down capture ratio of 60 percent.

 

I looked back at Up and Down Capture Ratios for over 80 mutual fund categories for the five years ended 2/28/11. The styles with the largest capture in up markets are no surprise. They include Latin America Stock (which was number one at 171%), China, Asia ex-Japan and broad Emerging Markets funds. Real Estate and Technology also did quite well in up markets. The latter is no surprise, but the performance of REITs reminds us of how much that sector has changed from the days when investors considered them to be akin to Utilities, with high dividends and low volatility relative to the broad stock market. As you might expect, these categories all have very high Down Capture Ratios as well.

 

Tamer combinations of Up/Down market Capture are found in many of the so-called “Alternative” categories of mutual funds. Several of the fund styles I cover closely in my work, such as Long-Short, Bank Loans, High Yield, and Conservative Allocation Funds sport historical Up and Down Capture ratios between 30% and 60% in most cases.

 

In summary, Capture Ratios may seem complex at first glance, but they are simply a way to separate your historical investment experience into up and down markets. By better understanding how different investment styles perform in varying market conditions, you will be better-prepared to take on the next market cycle, and avoid feeling like you have been “captured” by the market’s evil side when the current two-year, 100% rise in the S&P 500 Index eventually gives way to tougher times.

 

Robert A. Isbitts, a 25-year industry veteran, is a newsletter writer, published author, and investment strategist. He is also the lead-manager of an asset allocation mutual fund and a global equity mutual fund. For more information on those mutual funds, visit www.easfunds.com. His second book, “The Flexible Investing Playbook” – Asset Allocation Strategies for Long-Term Success” was published by John Wiley & Sons in August, 2010.

 

(c) Rob Isbitts