Mutual Fund Unlocked: Use capture ratio intelligently

The volatility in the market has increased in the last few years and hence analysing potential investment avenues has become increasingly difficult. The ratios such as standard ratio, beta and alpha are good to analyse, however, they will not help you in selecting a fund that can reduce volatility. The reason being these metrics measures a security’s symmetrical correlation to the market. A typical investor would like to be in sync with rising the market while would like to exit investments if the market falls.

Hence, to understand the performance of the funds with a better perspective, you can use capture ratio. Statistics show whether a given fund has gained more or lost less than a given benchmark during periods of market strength and weakness and if so, by how much.

The upside capture ratio of a fund is calculated by taking the fund's monthly return when the benchmark had a positive return and dividing it by the benchmark return during that same month. Similarly, 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.

To make it simpler, if the market moves up by 10 per cent during a period and in the same period, the fund’s NAV has moved up by 15 per cent, the upside capture ratio will be 1.5 (15 divided by 10). On the other hand, if the market has gone down by 10 per cent and the fund has gone down by just 7 per cent, the downside capture ratio is 0.7.

Therefore, a fund is good if its upside capture ratio is greater than one and its downside capture ratio is less than one. It offers a relatively straightforward way to evaluate a fund's historical performance during both rallies and down markets.

An ideal fund is one that has higher upside capture ratio and lower downside capture ratio, however, you can select funds based on your risk profile. Hence, if you are a risk aversive investor, your preference should be those funds that have lower downside capture ratio. For aggressive investors, funds with higher upside capture ratio will be suitable. To use this ratio in an optimum way you should analyse as many time periods as possible to find the most consistently performing funds and reject those funds that do not have an upside capture ratio of 1 or more over multiple periods.