Manager Evaluation: Capture Ratios and Drawdown

An old song says that "you got to accentuate the positive and eliminate the negative." Of course a successful portfolio manager aims to capture the positive and not capture the negative in markets.

If successful, what would that mean for the upside capture ratio?

That's not quite enough. A passive index fund will have a positive upside capture ratio.

That's not necessarily indicative of success. A manager could get this simply by leveraging the benchmark.

Exactly. Recall that the upside capture ratio is the percentage of market gains that the manager captured, while the downside capture ratio is the percentage of market losses that the manager captured. For success, you want to accentuate that positive while nearly eliminating the negative.

What would you expect the ratio of upside capture to downside capture to be for a passive index fund?

Right!

Unlikely; it should simply be 1.

A passive fund would get 100% of the upside and 100% of the downside, for an "upside-to-downside" ratio of 1.

Suppose now that the manager decided to start with the index but lower the beta, investing only 50% in the market and 50% into cash equivalents. What would the approximate upside capture ratio be now?

Yes!

No, it should be 50% since there's 50% market exposure.

And what would the "upside-to-downside" ratio of capture ratios be now?

That's it; still 1.

No, it's still 1.

Leverage up, leverage down, whatever; the ratio of upside-to-downside capture will still be 1. The only way it will change is if the manager demonstrates some skill (or lack thereof) in perhaps greater tactical allocation during up markets than down markets.

Analyzing drawdowns and drawdown duration (time to recovery) is important as well, especially for some investors. Which investor characteristic would make these things particularly important?

Not really. Young investors have time to get that capital back.

Sure. If you're retiring in five years, you can't afford to take on a manager that tends to lose a large amount of capital. There's just no time to recover. The decision to cut losses after a downturn or hope for a recovery isn't an easy one. Maybe something fundamental has changed. Maybe investors are just scared and will be back in full force next year. It just depends. Careful analysis is needed for a manager to accentuate those positives and eliminate the negatives. Just don't be too optimistic about a manager's ability to actually do that consistently!

Not necessarily. There's no clear connection between tax issues and drawdowns, other than the opportunity to take advantage of capital losses.

To summarize: [[summary]]

It would be positive

It would be greater than the downside capture ratio

It would be larger than 1

Other responses

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Other responses

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Other responses

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Young

Short time horizon

Special tax circumstances

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