WINNING BY NOT LOSING
By Denise Slattery
With the Australian share market hitting a record high last week, finally beating its record high set nearly 12 years ago before the Global Financial Crisis, it is easy to focus on your portfolio in rising markets. However, it is just as important to understand the performance of a portfolio in falling markets.
By measuring the percentage gain or loss (on average), an investment experiences in a falling or rising market, you can gain valuable insight into how an investment may perform relative to an index over the long term. Is it better to outperform in a rising market, or protect your investment in a falling market?
Due to the irregularity of gains and losses, reducing the impact of the losses within an investment when markets are falling can have a material effect on the total return of an investment, particularly over the longer term. For example, to recoup the loss of 10% within an investment, a gain of 11.1% is required to return the value of your investment to break even. The return required to recover your losses increases dramatically as the loss increases. For example, a 50% loss would need a gain of 100% to break even. This relationship between gains and losses would suggest that trying to limit the losses within your investments has more impact on your portfolio over the long term than achieving an equivalent nominal positive return. This is because protecting your portfolio when markets are falling leaves more invested capital to grow when markets rise again, resulting in a faster recovery of your portfolio.
The downside capture ratio can be used to gain an understanding of how an investment performs in falling investment markets. It quantifies what percentage loss, on average, an investment experiences in a falling market. The downside capture ratio is calculated by taking an investment’s return when the benchmark has a negative return and dividing it by the benchmark return over the same period. A downside capture ratio of less than 100% indicates that an investment, will on average, outperform the benchmark during negative periods. A lower downside capture ratio indicates that an investment is expected to be better at protecting capital over the long term. On the flip side, an upside capture ratio greater than 100% indicates that the investment has outperformed its benchmark during positive periods on average.
To highlight the importance of an investment’s upside/downside capture ratio, the following chart provides an example of assessing an investment’s performance in rising and falling markets.
Let’s assume there are three investments with the following characteristics:
Fund A: Upside capture ratio of 100%, downside capture ratio of 100%
Fund B: Upside capture ratio of 120%, downside capture ratio of 100%
Fund C: Upside capture ratio of 100%, downside capture ratio of 80%
Assuming each fund invests $1,000 for 20 years, the chart shows the cumulative return for each fund:
- Fund A would have an ending value of $953
- Fund B, with the higher upside capture ratio, would have an ending value of $1,524
- Fund C, with a superior downside capture ratio, would have an ending value of $1,554
By limiting the losses in falling markets over this period, Fund C has produced a higher return than the other two funds.
Upside/downside capture ratios are a tool that the GFM Investment Committee uses when assessing investments for their inclusion on our list of preferred investments, as it is essential to protect a portfolio in a market downturn as well as produce returns when markets are rising.
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