‘Capture ratio’ shows us just how fragile returns can be

Giles Parkinson of Aviva Investors uses ‘capture ratio’ to explain why downside protection is even more important than investment returns.

Someone once said that the first rule of investment is “don’t lose money” and the second rule is “don’t forget the first rule”.

This may sound facile, yet it contains a profound truth; one that is central to how we think about risk. The reason lies in the distinction between the calculation of arithmetic average versus geometric average returns and the fact that aggregate portfolio returns are compounded over time.

An example should help make the point.

Imagine a coin flip where each outcome is equally likely, but heads pays 60%, while tails loses 50%. This sounds like an attractive bet since the expected return is the arithmetic average of five per cent. (This is because each flip has a 50% chance of being heads or tails, which halves the difference between the return and the loss).  Indeed, some active fund managers would describe this return profile as asymmetric, offering greater upside than downside.

But let’s roll the exercise forwards: a positive 60%return followed by a negative 50% loss followed by positive 60% gain then negative 50%. Despite the arithmetic average remaining at five per cent, the geometric average multiplies each outcome such that our errant coin flipper has lost 36% of their starting capital.

It is very hard to argue with maths. What was presented as a seemingly attractive bet overlooks the fact that a 100% return is required to return to breakeven after being down 50%. When assessing a prospective investment it is not enough to merely quantify the upside because the mathematics of compounding returns make it very difficult to recover from catastrophic losses.

Beyond the individual stock level, this logic also holds true for a portfolio. An investor who receives 16 per cent annually for a decade ends up better off than an investor who earns 20% a year for nine years and then loses 15% the tenth year.

Again, the mathematics of geometric compounding are responsible for the deleterious effect of one bad year on overall performance. This is what makes capture ratio a suitable metric for assessing fund returns on a risk-adjusted basis.

Capture ratio separates an historic return series into two buckets: months when the market went up, and months when the market went down, and looks at how an investment performed in each. Taking the average of the two population’s results in the investment’s capture of the upside/downside capture, and dividing one by the other, gives the overall capture ratio.

By giving attention to how a fund performs during negative periods for the market can show otherwise positive returns in a different light. For example, imagine a market that returns 16% for nine years and loses 16% in the tenth year. One fund unexcitingly performs in-line with the market during the up years but falls by half as much in the final year.

Overall it beats the market by one per cent annualised with a capture ratio of 2.00. Another fund excitingly beats the market by four per cent during the up years but falls by twice as much in the down year. While it has outperformed by a similar amount, the far inferior capture ratio of 0.63 speaks to the risk-adjusted manner in which these returns where achieved. 

Downside risk, i.e. the impact of loss, effectively hurts more than the equivalent percentage increase helps a portfolio’s return.

Back to our original example, viewed in this way you could argue that the asymmetry in outcomes now works the other way around: played out through time, which all investments are, it can pay to place more weight on the downside than upside. If you fail to lose money then all your other outcomes are probably good.

This is why we should “never forget the first rule”, and why focusing on capture ratios is so important when assessing investor skill.

No metric for doing this will ever be perfect, but looking beyond raw performance numbers and ascertaining whether a manager captures a decent amount of upside while protecting well on the downside is vital for assessing whether an investment manager has sufficient defensive qualities to take advantage of the mathematic quirks explained above.

*Giles Parkinson is co-manager of the Global Equity Endurance Fund at Aviva Investors.

©2020 funds europe

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