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Capture Ratios: a Popular Method of Measuring Portfolio Performance in Practice JOURNAL OF ECONOMICS AND FINANCE EDUCATION • Volume 2 • Number • Winter 2013 Capture Ratios: A Popular Method of Measuring Portfolio Performance in Practice Don R. Cox and Delbert C. Goff 1 ABSTRACT We provide a brief introduction to a simple measure of portfolio risk and return, the capture ratio, which is widely used in practice, but rarely noted in finance textbooks or literature. We describe the ratio and provide examples of its rather widespread use in the investing profession. Finally, we show a specific example of calculating capture ratios using a computer spreadsheet. Finance professors and their students can benefit from basic knowledge of this common practical performance measurement tool. Introduction Finance and investments textbooks typically discuss multiple measures of portfolio risk and return that are also commonly used in practice. Among the most commonly noted measures are alpha, beta, the standard deviation of returns, the Sharpe ratio, the Treynor ratio, tracking error, and the information ratio. There are other measures of portfolio performance that are used in practice, but are generally not covered in textbooks. Among the most popular of these alternative measures are the “up-market capture” and “down- market capture” ratios. Through our experience serving on advisory boards for endowment funds and working with investment professionals we have had the opportunity to see the frequency with which capture ratios are used in practice. And, through our research we have discovered other evidence suggesting that capture ratios are widely used in practice by investment advisors and consultants. There is, however, a dearth of information from academic research and/or textbooks on the capture ratios. The purpose of this paper is to provide a description of capture ratios and explain how they are used in practice. This information will be helpful for finance professors who want to make certain that their students are familiar with portfolio performance measures widely used in practice. We do not propose that capture ratios are theoretically superior to other measures of performance, but simply that any measure so widely presented and used in practice is worthy of attention by our peers. An example of the calculations that can be shared with students is given. 1 Don R. Cox, Professor of Finance, [email protected], and Delbert C. Goff, Professor of Finance, [email protected], Department of Finance, Banking & Insurance, Appalachian State University, Boone, NC 28608. 50 JOURNAL OF ECONOMICS AND FINANCE EDUCATION • Volume 2 • Number • Winter 2013 What Are Capture Ratios? Capture ratios provide information on how investment portfolios (and thereby investment managers) perform in up and down markets. The up capture ratio is a measure of a portfolio’s performance during periods where the benchmark portfolio is up. For example, an up capture ratio of 110 percent indicates that, on average, the portfolio outperforms the benchmark by 10 percent during periods when the benchmark is up. An up capture that is less than 100% indicates that the portfolio underperformed the benchmark during period when the benchmark returns were positive. Investment managers strive to have an up capture ratio that is high. The down capture ratio measures portfolio performance during periods when the benchmark returns are negative. For example, a down capture ratio of 80% indicates that, on average, the portfolio captured only 80% of the negative returns of the benchmark. Investment managers strive for a down capture ratio that is less than 100%, or at least less than their up capture ratio. The up capture ratio is calculated by dividing the annualized returns of the portfolio during periods that the benchmark returns are positive by the annualized returns of the benchmark during the periods the same periods. The first step in calculating the up capture ratio is to identify the periods (e.g., months or quarters) when the returns to the benchmark are positive. Next, annualize the returns for the benchmark and returns for the portfolio during the positive benchmark periods. Finally, calculate the ratio. That is: Annualized returns of portfolioduring periods with positivebenchmark returns Up Capture Annualized returns of benchmark during periods with positivebenchmark returns The formula for calculating the up capture ratio is: 1 nup y 1 r 1 i i1 Up Capture 1 nup y 1 s 1 k k1 Where: nup = number of positive benchmark returns sk = k-th positive benchmark return ri = portfolio return for the same period as the i-th positive benchmark return y = number of years, counting periods of positive benchmark returns only For the down capture calculation, portfolio and benchmark returns from the negative benchmark return periods are used instead of returns from the positive benchmark return periods (Zephyr Associates, Inc., 2011). How Widely Are Capture Ratios Used in Practice? We have had the opportunity to interact with investment professionals in a variety of settings and we have observed that they frequently include capture ratios in reports about manager or fund performance. In particular, we have seen capture ratios being highlighted in presentations related to the comparison, evaluation and selection of investment managers, and in presentations illustrating the type of important analysis information that an advisor can provide to an investing client. Our personal observations include multiple financial advisors/consultants from a wide variety of major investment firms – including Merrill 51 JOURNAL OF ECONOMICS AND FINANCE EDUCATION • Volume 2 • Number • Winter 2013 Lynch, UBS, Morgan Stanley, Deutsche Bank, Wells Fargo, and Smith Barney – as well as many smaller or independent advisors. A study by Nelson (2009) reports the results of surveys on investment screens used by financial planners. For 2008, 43.0% of respondents indicated occasional use of capture ratios, 42.0% indicated frequent use of capture ratios, and 15.0% indicated that they always used capture ratios (for 2009 respondents reported use of 58.6%, 30.1%, and 11.1%, respectively). These results provide significant recent evidence that capture ratios are widely accepted and widely used in practice by investment professionals. Finally, although we have not conducted a comprehensive search, we have frequently run across mutual fund annual reports and/or fact sheets that use capture ratios as part of the risk and return information presented by the fund. Just a few examples include the Alger China-US. Growth Fund, the Allianz AGIC Convertible Fund, the Wells Fargo Strategic Large Cap Growth Fund, and the Managers Special Equity Fund. In the September 2010 Management Commentary and Annual Report for the Oppenheimer Global Opportunities Fund, Frank Jennings, the portfolio manager for the fund states: “…we believe the best measures of our risk are what we refer to as upside and downside capture…. Over the last three years, the fund has performed better than the index in up markets, and almost equal to the index in down markets…We will seek to maintain this attractive risk/reward relationship for investors over the long term.” What Is the Appeal of Capture Ratios? As previously noted, there are numerous other measures of manager performance and risk (Sharpe ratio, Treynor ratio, information ratio, standard deviation, beta, etc.). Despite the array of measures, most of them depend in some way on the statistical measurement of variance. This presents two potential concerns: (a) measures that do not have a clear intuitive understanding by many non-professional investors, and (b) measures that treat the “pleasure” from gains as symmetrical with the “pain” from losses (based on models assuming behavior driven by expected utility). As proposed by Kahneman and Tversky (1979) and others, real-world investors often display “loss aversion” whereby they are more sensitive to losses than to gains. Capture ratios address both of these issues. A ratio that attempts to simply measure the percentage, or proportion, of market gains and losses that are captured by an investment manager is an idea that does not require any real understanding of statistical theory. Also, a measure that examines relative gains and relative losses separately may be useful for investors that display some degree of loss aversion, and even for different investors with different degrees of loss aversion. Textbook and Literature Review We searched 13 textbooks for information on capture ratios and could find no information on capture ratios in any of the textbooks examined. Table 1 lists the textbook searched. The only book that we found that provides coverage of capture ratios is Investment Manager Analysis by Frank J. Travers. This book is not a traditional textbook as the target audience appears to be professionals and not academics. Investment Manager Analysis provides a description of how to use and interpret the capture ratios, but it does not clearly explain and demonstrate how the ratios are calculated. 52 JOURNAL OF ECONOMICS AND FINANCE EDUCATION • Volume 2 • Number • Winter 2013 Table 1 - Textbooks Searched For Information on Capture Ratios Textbook Title Authors Essentials of Investments, Eighth Edition Bodie, Zvi; Kane, Alex; Marcus, Alan J. Fundamentals of Investing, Eleventh Edition Gitman, Lawrence J.; Joehnk, Michael D.; Smart, Scott B. Fundamentals of Investments, Fifth Edition Jordan, Bradford D.; Miller, Thomas W. Fundamentals of Investment Management, 9th Hirt, Geoffrey; Block, Stanley Edition
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