It is appropriate to prefer strategies that fully participate in up markets, and that provide protection in down markets, and investors frequently employ up-market capture ratio vs. down-market capture ratio to evaluate investment strategies. However, because of the way statistics are calculated, comparing a strategy's up-market capture to its down-market capture provides little, if any, information beyond knowing that the strategy outperformed its benchmark on a risk-adjusted basis.
It seems logical to assume that a portfolio manager whose strategy had greater up-market than down-market capture demonstrated either timing skill (higher beta in up than in down markets) or a defensive process (added more alpha in down than in up markets), but there is little evidence to support either assumption. Most of the time, the difference between strategies' up-market and down-market capture ratios offers little information about portfolios' market-conditional performance. Instead, the difference in capture ratios is simply another measure of unconditional alpha, which means it should not be viewed as an additional indicator of manager skill.
To understand market-conditional behavior, we recommend researchers look deeper: To evaluate a manager's timing skill, compare the portfolio's beta in up markets to its beta in down markets. To investigate if an investment process is "defensive," compare the portfolio's alpha (market-adjusted return) in down markets to its alpha in up markets.
Figure 1 illustrates three ways that an investment manager can achieve higher up-market than down-market capture. The first set of columns relates to a 5% down market. The second set describes a 15% up market.
- Market timing: The first row represents successful market timers, which have higher beta in up markets than in down markets. For this analysis, it does not matter whether the shift in beta is achieved by rotating the stocks in the portfolio or by using cash. Regardless of how it is achieved, timing skill will result in the portfolio returning more than the market in up markets and losing less than the market in down markets. In this example, the up-market capture is 110%, the down-market capture is 90% and the difference is 20%.
- Defensive strategy: The second row represents defensive strategies, which add more value in down markets than in up, and therefore have lower down-market capture than up-market. In this example, the strategy produces an alpha of 1.5% in the down market and an alpha of 0.25% in the up market, while having a beta of .90 in both. That results in a 32% difference between up-market and down-market capture ratios.
- Unconditional alpha: The third row of the table represents a manager that has skill that's unrelated to market direction. The strategy's beta is always 1.00 (no timing), and the alpha is the same in up and down markets (not a defensive strategy). Despite the lack of timing skill and the equal success of the strategy whether the market is up or down, its up-market capture is 27% more than its down-market capture. The reason is that the capture metrics are calculated as the portfolio's average return divided by the market's average return. Positive alpha results in less than 100% capture in down markets and more than 100% capture in up markets. As a result, the up-market capture is higher than down-market, even though the alpha is uncorrelated with market direction.