By LARRY SWEDROE
Investors concerned about risk care about more than just volatility. They also care about tail risk, including how investments perform relative to benchmarks during good times and bad. With that in mind, Morningstar began reporting “capture ratios” in 2011. Basically, the upside/downside capture ratios show whether a given fund has outperformed (gained more or lost less than) a broad market benchmark during periods of market strength and weakness, and if so, by how much. Morningstar provides a detailed explanation of their capture ratio here.
In their study Capture Ratios: Seizing Market Gains, Avoiding Losses, and Attracting Investors’ Funds, published in the December 2019 issue of The Journal of Investing, authors Timothy Marlo and Jeffrey Stark demonstrated that mutual fund investors utilise capture ratios when allocating money to mutual funds—stronger fund flows respond to the upside capture ratio if the current market state is up, and stronger fund flows respond to the downside capture ratio if the current market state is down. Taking advantage of this knowledge, mutual funds market capture ratios to the public.
Marlo and Stark also constructed a measure of relative capture ratios, or “skill”, calculated as the difference between a fund’s upside and downside capture ratios. A fund with positive (negative) skill is one in which the upside (downside) capture ratio is greater than the downside (upside) capture ratio. They found that their skill measure was positively and significantly related to future one-year fund performance.
Aron Gottesman and Matthew Morey, authors of the study What Do Capture Ratios Really Capture in Mutual Fund Performance?, published in the October 2021 issue of The Journal of Investing, examined whether the upside and downside capture ratios measure the portfolio manager’s skill or are just a proxy for market beta — the strength of capture ratios may be driven by the beta of the fund and nothing else. They also examined whether Marlo and Stark’s skill measure predicted future fund performance over longer horizons, specifically three and five years.
To measure performance, they used two measures: skill and alpha versus a six-factor model (beta, size, value, investment, profitability and momentum). The skill measure is the difference between the given fund’s upside and downside capture ratios. For example, if the upside capture ratio is 95 while the downside capture ratio is 65, the manager captures 95 percent of the benchmark’s returns when those returns are positive but only captures 65 percent of the benchmark’s returns when they are negative. In this example, the skill measure is 95 – 65 = 30. Conversely, if the upside capture ratio is 120 while the downside capture ratio is 130, the manager captures 120 percent of the benchmark’s returns when those returns are positive but captures 130 percent of the benchmark’s returns when they are negative (hence, its returns are more negative than the benchmark index). In this example, the skill measure is 120 – 130 = -10. Their data sample included all U.S. funds in the Morningstar database over the period 1990-2019. Following is a summary of their findings:
- The mean upside capture ratios were below 100 in all three cases (one year, three years and five years — on average, funds generally underperformed the benchmark when the market was up.
- The mean downside capture ratios were below 100 in the one-year, three-year and five-year cases — on average, funds generally outperformed the benchmark when the market was down.
- The relationship between the capture ratios and beta is strongly positive — the correlations were well above 80 percent and typically well above 90 percent and statistically significant at the 1 percent confidence level — suggesting that using capture ratios as evidence of manager skill may be misattributing performance. In other words, the strength of capture ratios may be driven by the beta of the fund, not skill.
- Beta predicts future performance about as well as the capture ratios do — beta is a strong substitute for the capture ratios, and hence the capture ratios themselves are not useful to investors.
- The skill measure was negatively and significantly related to three-year and five-year out-of-sample alpha, suggesting that longer-term investors do not benefit from investing in funds with higher skill.
Their findings led Gottesman and Morey to conclude: “Capture ratios are quite overrated. They do not seem to ‘capture’ manager ability but rather just the beta of the portfolio.” They explained: “If managers have real skill in timing the market or in picking the right stocks to hold, we should not necessarily see such a direct and consistent pattern between beta and these capture ratios.” They added: “While there is evidence from Marlo and Stark that the skill measure can predict one-year future fund performance, we find they are negatively and significantly related to future fund performance over longer periods than one year.”
Investor takeaway
For investors, the takeaway is that while capture ratios are widely used, they do not seem to “capture” manager ability but rather the portfolio’s sensitivity to the market beta factor. Forewarned is forearmed.
Important Disclosure: The information contained in this article is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained in this article is based upon third party information available at the time which may become outdated or otherwise superseded at any time without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. Neither the Securiites and Exchange Commission (SEC) nor any other federal or state agency have approved, confirmed the accuracy, determined the adequacy of this article. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®, Buckingham Strategic Partners® (collectively Buckingham Wealth Partners). LSR-21-172
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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