Question: I see that Morningstar.com displays Upside and Downside Capture Ratios for funds. What do those statistics mean?
Answer: This set of statistics, which appear on the "Ratings and Risk" tab for each individual fund, offer a relatively straightforward way to evaluate a fund's historical performance during both rallies and down markets. When used in conjunction with other risk measures, upside/downside capture ratios can be a handy tool for monitoring your holdings' performance and conducting due diligence on possible additions to your portfolio.
How Are the Ratios Calculated?
The term "upside/downside capture ratio" might sound wonky, but the concept is pretty straightforward. In short, the statistics show you whether a given fund has outperformed--gained more or lost less than--a broad market benchmark during periods of market strength and weakness, and if so, by how much.
Upside capture ratios for funds are calculated by taking the fund's monthly return during months when the benchmark had a positive return and dividing it by the benchmark return during that same month. Downside capture ratios are calculated by taking the fund's monthly return during the periods of negative benchmark performance and dividing it by the benchmark return. Morningstar.com displays the upside and downside capture ratios over one-, three-, five-, 10-, and 15-year periods by calculating the geometric average for both the fund and index returns during the up and down months, respectively, over each time period.
An upside capture ratio over 100 indicates a fund has generally outperformed the benchmark during periods of positive returns for the benchmark. Meanwhile, a downside capture ratio of less than 100 indicates that a fund has lost less than its benchmark in periods when the benchmark has been in the red. All stock funds' upside and downside capture ratios are calculated versus the S&P 500, whereas bond and international funds' ratios are calculated relative to the Barclays Capital U.S. Aggregate Bond Index and MSCI EAFE Index, respectively. For some context, we also show the category average upside/downside capture ratios for those same time periods.
What Do the Numbers Mean?
If both the upside and downside capture ratios for a fund are 100, that means the fund moved in lockstep with the benchmark during both up and down markets. For example, S&P 500 Index trackers like Vanguard 500 Index (VFINX) show upside/downside capture ratios that are just a hair away from 100. (The funds' expense ratios are the main reason they don't track the benchmark perfectly.)
But for most actively managed funds, upside and downside capture ratios will illustrate a more significant divergence from the benchmark. For example, PIMCO Total Return (PTTAX) has a three-year upside capture ratio of 120.23% and a downside capture ratio of 86%, which indicates that it outperformed the Barclays US Aggregate Bond Index by 20.23% in up markets and "captured" only 86.00% of its benchmark's negative performance during market declines. Such a strong record of upside potential coupled with downside protection means the fund is a worthwhile candidate for further investigation.
Keep in Mind the Caveats
While PIMCO Total Return demonstrates a "best of both worlds" performance pattern, most funds will have a bigger trade-off between their upside and downside performance. If a fund has a sizable up-market performance versus its index, it is likely to have subpar downside performance, and vice versa.
Moreover, it's worth bearing in mind that all funds within a given asset class are compared to a single market benchmark. As noted earlier, we use the S&P 500 for U.S. stock funds, the MSCI EAFE for foreign-stock funds, and the Barclays Aggregate Bond Index for bond funds. If the manager uses an investment style that's dramatically different than the benchmark, you can expect that its upside/downside capture ratios will be striking.
Take Fidelity Short-Term Bond (FSHBX), for example. Because its interest-rate sensitivity is much more muted than that of the Barclays Capital Aggregate Bond Index, its upside/downside capture ratios show that it has strongly underperformed the benchmark when the index has generated positive returns while dramatically outperforming it on the downside. In such situations, it can be useful to compare the fund's upside/downside capture ratios versus the benchmark with those of other funds in the same category--in this case, short-term bond funds--against the same benchmark.