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Don Yusten

August 01 , 2016

Portfolio Risk: Understanding the Upside/Downside Capture Ratio

Portfolio Risk: Understanding the Upside/Downside Capture Ratio

During a conference call with PIMCO last week several comments were made about the upside / downside capture ratio of one of the portfolios they were discussing. The upside/downside capture ratio was rarely heard about prior to the last recession. As markets become more volatile, looking at a portfolios downside capture ratio has taken on greater significance. The downside capture ratio is a comparison of how far an investment has fallen relative to its index during downturns and is one way to evaluate a portfolio’s riskiness.


Most managed portfolios are measured against a market index. There are two ways to beat the index and fuel investment growth: by earning more than the market or by losing less than the market. The upside / downside capture ratio is used to evaluate how well a fund has performed relative to its index for a certain period of time.  The ratio is calculated by dividing the portfolio / manager's returns by the returns of the index during the up/down-market and multiplying that factor by 100.


A portfolio’s downside capture ratio will indicate whether a fund has the potential to lose more or less than the market during periods of market weakness. For example, if over the course of a downturn a fund fell only 96% of the decline of the index or market, its downside capture ratio was 96%. If it fell 5% more than the market, its downside capture ratio was 105%. Consistently losing less during downturns can be instrumental in producing larger balances and better outcomes for the long-term investors. Funds that limit downside risk tend to also provide a smoother ride, making it easier for those with long-term objectives to stay the course during turbulent markets.


The ability to achieve superior outcomes by losing less is an example of what’s known as the “arithmetic of loss”. Here is an example of this: If a $1,000 investment loses 50%, its value drops to $500. In order for the investment to return to the $1,000 level, that $500 must gain more than just the 50% it went down (which would only bring it to $750); it needs to double (see chart below). Digging out of a hole is never easy, but the shallower the hole, the shorter the climb. The farther an investment falls, the longer the path back to break even. This chart shows the relationship of declines to getting back to even. The chart is based on data for rolling five-year periods for the 20 years ended December 31, 2015.


At Security our objective is to help your investments do better in periods of downturn and perform consistent with markets when markets are rising. If you would like to learn more about what a more stable portfolio could me for your investments, please call one of our Investment professionals at Security National Bank.

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