Alts University: What are Upside and Downside Capture?

Whiteboard Video Series: What are Upside and Downside Capture?

Watch this short 5-minute educational video to learn more about upside and downside capture and what they mean for your client portfolios.



As part of our ongoing University of Alts content library, today we're going to cover Upside and Downside Capture Ratios.

As always, we'll start with a definition. Upside and downside capture measures how a fund has historically performed relative to its broad market benchmark during times of market strength – or positive returns – and weakness – or negative returns.

Next, let's talk about why these are important metrics to take into consideration when comparing funds. Up and down capture ratios provide a relatively reliable way to get a feel for expected fund performance during both market rallies and declines. An upside capture ratio of greater than 100 would indicate that a fund has historically outperformed the market during periods of positive returns, while a number less than 100 would indicate relative underperformance during these periods. Similarly, a downside capture ratio of greater than 100 would indicate that a fund has historically declined more than the broader market during periods of stress, while a down capture ratio of less than 100 would indicate that a fund has historically protected capital and declined less than the broader market during these negative periods.

While each metric is useful in isolation, what investors also should consider is the spread between these numbers. For example, while a fund may not capture 100% of the upside, if it is capturing even less of the downside and, thus, has a down capture ratio that is lower than its up capture ratio, the fund may still have the ability to outperform the market and potentially do so with even less risk over full market cycles.

Now, let's look at how you calculate these ratios and an example of how they may be used to analyze a specific fund. The formula for up and down capture looks like this: whereas you take the performance of the fund, divide it by the performance of the benchmark, and multiply the results by 100. For up capture you will use performance during months when the market is positive, and for down capture calculate this ratio for months when the market is negative. The individual monthly capture ratios can then be used to calculate a geometric average over longer time periods, typically three, five, and 10 years.

Earlier, we mentioned how the specific up and down capture metrics may be less important than the spread between the two numbers, in that a fund may still be able to outperform the market even if it isn't capturing 100% of the upside. So, let's look at how this may play out in a real-world example. First, consider a hypothetical fund with an upside capture of 60% and a downside capture of 40% versus the S&P 500. Using the time period from July 1998 through June 2018, an investment of $10,000 in the S&P 500 would have returned $34,999. Our hypothetical fund, despite only capturing 60% of the upside, managed to return $43,843 over this same time period.

Why did this occur? Because even though it didn't capture 100% of the up markets, it effectively protected capital during periods of market stress by only capturing 40% of the downside. This compounding effect not only led to improved returns, but also a reduction in overall volatility as measured by standard deviation.

Often, managers will tout their high-flying performance figures when markets are performing well. But in order to effectively select those funds that may be poised for longer-term outperformance and that may also perform well during difficult market environments, it is incredibly important to consider the overall behavior of a fund by analyzing both the upside and downside capture ratios, as well as the spread between the two metrics.