Volatility lies at the core of all kinds of investment havens. Especially when it comes to equity as an asset class, market fluctuations can be a boon as well as a bane. A conservative investor may get nightmare thinking about losses caused due to volatility. Conversely, an aggressive investor may find it helpful in price discovery of his investment.
Here, one point about volatility needs to be underscored. The more an equity fund loses value during a slump, the harder the fund manager finds it to recover the fund losses during a market rally. Thus, apparently you cannot escape volatility altogether in mutual fund investments. You can, however, find a way to select a fund which retains value irrespective of the market conditions.
Now you might wonder, “Is there a tool which may identify a robust mutual fund?”
Yes of course…it’s the “Capture Ratios”!
Let’s get a deeper understanding of these ratios before moving to its application.
Capture Ratio: An introduction
Capture ratios have an analytical structure which indicate the intrinsic strength of a mutual fund to face market turbulence. It reveals such information which trailing returns are unable to disclose.
It breaks down the complex annualised returns to show outperformance/underperformance of the fund during a market rally/slump. Such performance is shown with respect to a broad-based benchmark like Nifty or Sensex.
It shows attitude of the fund manager towards risk. It also highlights his capacity to render higher risk-adjusted returns.
Capture ratios are expressed in percentage. You may find capture ratio for the period one/three/five/ten/fifteen years in fact sheet of the fund.
Capture ratios are broadly of two types: upside capture ratio and downside capture ratio.
Upside Capture Ratio
The upside capture ratio is used to analyse performance of a fund manager during bull runs i.e. when the benchmark had risen. The ratio is expressed in percentage.
It is calculated by dividing fund returns by the benchmark returns during an up market period. The formula is given below:
Upside Capture Ratio = (Fund returns during bull runs/Benchmark Returns)*100
It shows ability of the fund to beat the benchmark at the time of bull runs. You get an idea about how much more returns the fund earned as compared to the benchmark.
An upside capture ratio of more than 100 indicates that the fund beat the benchmark during the period of market rally. A fund having upside capture ratio of say 150 shows that it gained 50% more than its benchmark in bull runs.
Downside Capture Ratio
The downside capture ratio is used to analyse how a fund manager performed during bear runs i.e. when the benchmark had fallen.
It is calculated by dividing fund returns by the benchmark returns during a down market period. The formula is given below:
Downside Capture Ratio = (Fund returns during bear runs/Benchmark Returns)*100
You get an idea about how much lesser returns the fund lost as compared to the benchmark at the time of bear runs.
A downside capture ratio of less than 100 indicates that the fund managed to lose less than the benchmark during the period of market slump. A fund having downside capture ratio of say 80 shows that it lost 20% less than its benchmark in bear runs.
Things to keep in mind while using Capture Ratios
When you are using capture ratios for mutual fund comparison, you need to bear a few things in mind.
- Always use a capture ratio which matches your investment horizon. A 3-year capture ratio would be irrelevant for a 5-year goal.
- The benchmark used to compare performance of a mutual fund should match the fund category. You cannot use Sensex to compare performance of a debt fund.
- Always compare apples-to-apples i.e. capture ratios of funds belonging to the same category. Don’t compare performance of an equity fund with a debt fund.
How to use capture ratios in Mutual Fund Selection?
Capture ratios can be a handy tool to select an appropriate mutual fund. The basic thumb rule is to choose a fund that gains more than the benchmark during a boom; and loses less than the benchmark during a bust.
While comparing mutual funds, choose the one with higher upside capture ratio and lowest downside capture ratio. The reason being that the fund manager needs to justify the fee charged from the investors. Else you would be better off investing in low-cost index funds.