How well is your fund protecting downside when markets fall?
Use Downside Capture Ratio to find out how well your fund is protecting the downside when markets correct.
Apr 2024
4 mins read
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Choosing the right fund from the 440 open ended equity schemes that exist as of March 2024 (Source: AMFI) can be a daunting task. There are 11 categories of equity funds and within each category there are multiple schemes offered by different fund houses.
One of the most important aspect investors consider is the performance of the fund – how much return the fund has generated over different time periods. But many investors may overlook one aspect of performance measurement - downside capture ratio.
Downside capture ratio provides insights into how well a fund mitigates losses during market downturns, which is crucial for managing risk and preserving capital.
In this article, we'll delve into what downside capture ratio is, how it's calculated, and why it's important for investors.
What is Downside Capture Ratio?
Downside capture ratio measures a mutual fund's ability to limit losses during bear markets or downturns in the market. It indicates how much downside risk is mitigated relative to its benchmark. Essentially, it assesses the fund's ability to preserve capital during unfavorable market conditions.
Calculation of Downside Capture Ratio
The formula for calculating downside capture ratio is relatively straightforward:
Downside capture ratio is calculated by taking the fund's monthly return during the periods of negative benchmark performance and dividing it by the benchmark return. (Source: Morningstar.com)
- Fund's return/Benchmark Return * 100
The numerator represents the fund's return during periods when the market or benchmark is experiencing negative returns. The denominator is the benchmark's return during the same time frame. A lower downside capture ratio indicates better risk management and downside protection.
A downside capture ratio of less than 100 indicates that the fund has lost less as compared to the benchmark when the market is in red.
Why Downside Capture Ratio Matters
Risk Management: Downside capture ratio provides valuable insights into how effectively a mutual fund manages risk. Investors are generally more concerned about protecting their capital during market downturns than during periods of growth. Funds with higher downside capture ratios are better equipped to navigate volatile market conditions, reducing the risk of significant losses for investors.
Preservation of Capital: Preservation of capital is paramount for long-term wealth accumulation. Mutual funds with strong downside capture ratios are more likely to preserve investors' capital during bear markets, helping to maintain portfolio value over time. This can provide peace of mind to investors, knowing that their investments are less susceptible to severe downturns.
Suppose a fund’s NAV falls from 50 to 40, it represents a downside of 20%. To recover this loss, the fund has to deliver 25% to come back to the previous NAV of 50. Thus, looking at downside capture is equally important while analysing a fund’s performance.
Performance Consistency: Consistently protecting against downside risk can contribute to the overall performance consistency of a mutual fund. Funds with a track record of maintaining downside protection tend to exhibit smoother and more predictable returns over time, which can be appealing to investors seeking stability in their investment portfolios. Funds with better downside capture can encourage investors to stay invested in funds for longer and in turn reap the benefits of compounding over long run.
Alignment with Investor Objectives: Different investors have varying risk tolerances and investment objectives. For investors prioritizing capital preservation or those nearing retirement, downside capture ratio serves as a valuable metric for assessing whether a mutual fund aligns with their risk preferences and financial goals.
Limitations of Downside Capture Ratio
While downside capture ratio provides valuable insights into risk management, it's important for investors to consider its limitations:
Historical Perspective: Downside capture ratio is based on historical data and may not accurately predict future performance, particularly during unprecedented market conditions or structural changes in the financial markets. There is no assurance that the fund will continue to offer better downside capture in future.
Single Metric: Downside capture ratio is just one of many metrics investors should consider when evaluating mutual funds. It should be analysed within the same peer group of funds. For instance, the downside capture ratio of a Small Cap Fund should not be compared with a Large Cap Fund. Further, it should be used in conjunction with other performance measures, such as standard deviation, Sharpe ratio, rolling return, and maximum drawdown, to gain a comprehensive understanding of a fund's risk-return profile.
Conclusion
Downside capture ratio is a valuable metric for investors seeking to evaluate mutual funds based on their ability to manage risk and preserve capital during market downturns. By assessing a fund's performance relative to a benchmark during negative market conditions, investors can make more informed decisions aligning with their investment objectives and risk tolerance. However, it's essential to recognize the limitations of downside capture ratio and consider it alongside other performance metrics to gain a holistic view of a mutual fund's risk-return profile.
It should be looked at over different market cycles since each fund follows a different style of portfolio. For instance, value stocks may offer some resilience as compared to growth stocks during economic uncertainty. Hence, a fund which follows a value style may offer better downside capture when value is in favour in comparison to growth-styled funds. A fund with a higher cash can also protect downside when market falls. Hence, investors should also consider other aspects too while analysing a fund’s performance.
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PGIM India Asset Management Private Limited
(CIN - U74900MH2008FTC187029)
Toll Free Number: 1800 266 7446
Email: care@pgimindia.co.in
This is an Investor Education and Awareness Initiative by PGIM India Mutual Fund.
All the Mutual Fund investors have to go through a one-time KYC (Know Your Customers) process. Investor should deal only with the Registered Mutual Funds (RMF). For more info on KYC, RMF and procedure to lodge/redress any complaints, visit https://www.pgimindiamf.com/ieid.
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY. Read more
All the Mutual Fund investors have to go through a one-time KYC (Know Your Customers) process. Investor should deal only with the Registered Mutual Funds (RMF). For more info on KYC, RMF and procedure to lodge/redress any complaints, visit https://www.pgimindiamf.com/ieid.
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY. Read more
The information contained herein is provided by PGIM India Asset Management Private Limited (the AMC)
on the basis of publicly available information, internally developed data and other third-party
sources believed to be reliable. However, the AMC cannot guarantee the accuracy of such information,
assure its completeness, or warrant such information will not be changed. The information contained
herein is current as of the date of issuance* (or such earlier date as referenced herein) and is
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each investor is advised to consult his or her own professional investment / tax advisor / consultant for advice in this regard.
The information contained herein is provided on the basis of and subject to the explanations, caveats and warnings set out elsewhere herein.
The views of the Fund Manager should not be construed as an advice and investors must make their own investment decisions regarding investment/ disinvestment in securities market and/or suitability of
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