Why you should care about the "Capture Ratios" in your portfolio

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I was in a meeting with my partners this morning when I exclaimed, "you know, we're all geeks to some extent in this business!" Here's proof of my own geekiness...

Some investors want their portfolio to rise faster than the market, even though it takes a bigger hit when the market pulls back.  What they don’t realize is that a properly constructed portfolio will not only be less volatile, but it’ll also make more money in the long run.  The Capture Ratio is an important way to measure investment performance and to construct a more profitable portfolio.

What is the Capture Ratio?

The capture ratio measures the performance of an investment through all the ups and downs of the market.  The “up capture ratio” measures the performance of a fund when the market is rising and the “down capture ratio” measures performance when the market is declining. 

For example, if a fund is up 6% when the Standard and Poor’s 500 index is up 10%, its “up capture” is calculated as:

6%/10% = 60%

If the fund is down 4% when the S&P 500 pulls back 10%, its “down capture” is 40%. 

If you can construct a portfolio where the up capture is higher than its down capture, your compound returns will be higher throughout the market cycles.  In other words, if you can capture 60% of the upside and only 40% of the downside, you’re well on your way to creating a more profitable portfolio.

An Example

Here are two exchange traded funds (ETF’s) compared side-by-side.  The State Street SPDR (SPY) tracks the S&P 500 index, and the PowerShares S&P 500 Low Volatility ETF (SPLV) invests in only the lowest volatility stocks that make up the same S&P 500 index. 

Comparing these two investments is like the old race between the tortoise and the hare.  SPY is the hare – fast and responsive to changes in the direction of the market, while SPLV is the tortoise – a bit steadier in its growth.  Here’s a comparison of the capture ratios of each of these investments:

When the market was rising SPLV was rising only about 64% as fast.  But when the market was falling, it was falling only about 21% as fast. 

Looking at how those investments grew over time, you can see from the chart below that when the market is rising, the gap between the two funds narrows because the hare accelerates faster, but when the market is correcting downward the gap widens because the tortoise isn’t chasing the hare downward.  Most importantly, SPLV - the lower volatility fund, or the tortoise - was worth more than SPY, demonstrating the value of the lower volatility investment during this time period.

What are the disadvantages to a lower volatility portfolio?  It’s not as thrilling to watch when the market is rising…but over time it makes for easier sleeping.  It also takes patience to see its advantages – after several market cycles of ups and downs its advantages become obvious. 

Those who judge their investment performance solely by comparing it to an index when the market is rising are looking at only one dimension of performance.  By also measuring volatility and the capture ratios, an investor has a more complete view of performance, and will be more satisfied with their results in the long run.