Market volatility - back with a vengeance!
Last week's Hedge Clippings briefly touched on market volatility (interestingly it was 19 October, the anniversary of the 1987 crash) and the risk of averages when grouping funds. Given the continuing volatility this week, and with the expectation of more to come, it's worth focusing on the best way to analyse a fund's downside risk.
There are a number of risk factors apart from volatility or standard deviation which are pretty well understood and known. Basics such as maximum drawdown, % positive and negative months, worst month etc. are frequently used and quoted.
However a couple we look at that are neither well known, or it seems frequently quoted are Up Capture and Down Capture ratios. Put simply, a fund's up capture ratio over a specific time period (the longer the better) shows how much of the market's positive performance a fund "captures". And importantly given we're talking about volatile markets, the down capture ratio measures how much of the market's negative performance a fund captures.
The key to accurately measuring each is not to simply measure the average positive or negative performance of the fund vs. the market. Instead, each is calculated by measuring the market's cumulative performance for all its positive or negative months, and then calculating the cumulative performance of the fund over those same months, and expressing that as a percentage, with a result of 100% meaning the fund tracks the index exactly.
For up capture, any number less than 100% means the fund underperforms in positive markets, and if the number is greater than 100%, the fund outperforms when the market is rising.
More importantly in the current environment, for down capture, a result less than 100% means the fund falls less than the market, while a negative number means the fund provides positive returns when the market falls.
Comparing and analysing funds is never easy, but by looking at the down capture ratios of different funds over various time periods will provide a useful guide when putting together a portfolio of funds.
Two important factors to remember of course are that the longer the track record of the fund, the more data points that are available to measure, and thus more instances of rising and falling markets - and secondly, that while a useful tool to understand a fund's performance, it is only past performance being measured.
