sortino ratio and Capture Ratios uses in Evaluating Mutual Fund Performance and Risk

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Marketopedia / Importance of Personal Finance / sortino ratio and Capture Ratios uses in Evaluating Mutual Fund Performance and Risk

In this chapter, we will discuss two other ratios related to the mutual fund performance/risk measures, i.e. the Sortino Ratio and the Capture Ratios. These are fairly easy to understand, so we will try to keep this chapter as a short note.

In the past chapter, we saw the Sharpe Ratio and its formula. Recall, this looks like –

Sharpe ratio = [Fund Return – Risk-Free Return]/Standard deviation of the fund

When considering the denominator, it’s important to note that it includes ‘Standard Deviation’, a measure of risk.

What sort of risk?

We are discussing the risk of returns deviating from the average expected returns. This variance can be either positive or negative.

Let me explain, have a look at the image below –

This sample data for a Mutual fund is used to calculate the daily return and the average daily return of this time series.

The average return is 0.108%.

I work out the excess return by taking the daily return of 4th August 2020 (1.23%) and subtracting the average return (0.108%).

Hence, Excess Return –

= 1.23% – 0.108%

= 1.13%.

Of course, you square this return to get the variance, from which you further calculate the standard deviation or the risk.

My point here is that when you take the excess return, you will see a mix of positive and negative values. Profits are distinguished by a positive figure while losses correspond to negative figures.

Now, let us look at the Sharpe ratio again –

Sharpe ratio = [Fund Return – Risk-Free Return]/Standard deviation of the fund

By taking the ‘standard deviation’ into account in the denominator, we adjust the return per unit of risk. It should be noted that risk encompasses both positive and negative returns.

We don’t want to punish the fund for positive results; we should only be concerned with the negative ones.

The Sortino’s ratio helps in this regard.

The Sortino Ratio is an enhancement of the Sharpe Ratio, with the denominator containing only ‘downside risk’.

Hence, the Sortino’s Ratio is –

= [Fund Return – Risk-Free Return]/Downside Risk

The purpose of Sortino’s ratio is to calculate the return adjusted for only the downside risk. Like the Sharpe ratio, a higher Sortino’s ratio is preferable.

Apart from this one change, there is not much difference between the Sharpe and Sortino’s Ratio.

– Capture Ratios

The capture ratios are rather intriguing to me. In my estimation, they outshine all other metrics and get right to the heart of the matter.

I’d like to share a tale from my college days before moving on to the capture ratios.

We were a group of friends in our first year of Engineering, full of youth and ambition, yet still striving to find our way.

A group of us, ranging around 8-10 individuals, used to fill our days playing cricket and missing classroom sessions. We often spent long hours in the parking lot just conversing over trivial matters – that was a great deal of fun.

We had such a blast that our exams went completely out of sight, so much so that the majority of us only just managed to pass.

This one guy in the group was unique. He partook in all the activities with everyone else; socialising, playing cricket and staying out late, but when exam time came around he went home to studiously study and improved his grades beyond the rest of us. Even though his marks may not have been remarkable, his efforts paid off.

We wondered at this man’s ability; it’s certainly a familiar sort of situation that many readers here may have encountered during their college years.

But why am I telling you this story? Well, there is a reason for it.

My friend is really wise; he knows how to have a great time with the gang, yet is able to recognize when he needs to buckle down. He understands that not preparing for tests can be dangerous.

Let’s take this analogy further and apply it to mutual funds. Suppose my acquaintance were a mutual fund and the others represented its benchmark index.

When the group had a good time, my friend, the mutual fund, also joined in the success to his full potential.

When it was time to study, the benchmark did not perform as well as expected; however, this friend had implemented effective risk management strategies and ended up doing better than the group.

Summarising his performance, he had the most enjoyable time while managing risk successfully and performing somewhat better than the others.

The summary is nothing but the ‘Capture Ratio’.

The capture ratio indicates the degree to which a fund either enjoyed the positive returns of its benchmark or was affected by its negative returns over a particular period.

Here is an example –

According to Morningstar India, the 3-year capture ratio of HDFC Top 100, Direct, Growth fund is available.

This fund has an upside capture ratio of 99, indicating that it has effectively captured nearly all of the Index’s gains.

Furthermore, the downside capture ratio stands at 119%, indicating that the fund has managed to obtain 119% of the Index’s downside returns.

The mathematics associated with capture ratio is simple, but that doesn’t matter to an investor since it’s not required.

What I would like you to recall is the upside capture ratio, showing how much of its benchmark’s positive returns the fund has gained. Similarly, the downside capture ratio outlines to what extent the fund has prevented losses from its benchmark.

When considering a mutual fund, it is essential to consider what the ideal capture ratio should be. You want to seek out one that captures 100% of any potential upside, if not more. Experience has shown us that we should try to minimise the potential downside capture ratio as much as possible.

Well, this is not easy 😊

A fund can have the potential for a significant gain, or substantial risk, but not both.

A fund can possess a high upside capture ratio, alongside a limited downside capture (such as HDFC fund), or alternatively, feature a low upside capture and equally low downside capture.

The Parag Parikh Long term equity fund has a 3-year capture ratio which is not particularly strong on the upside, yet its downside performance is noteworthy.

Investing is always a matter of trade-offs. You need to decide if you want the fund to take bigger risks in pursuit of higher returns, or if you prefer that it be managed conservatively.

I prefer to look at the latter, evaluating the consistency of the downside capture ratio over many years in order to gauge risk better.

Looking at HDFC Top 100 Regular Growth fund, it’s clear that the downside capture ratio over 3, 5, and 10 years has been kept consistent at 120, 119, and 111. Risk management is important to me and I value this metric more highly than the upside capture ratio.

The 3, 5, and 10 year upside capture ratios of the fund are quite promising, with numbers of 98, 103 and 104 respectively. Evaluating capture ratios over different years is essential because the consistency is key – it does not matter whether the upside or downside ratio is analysed.

With all that I have covered in the previous chapter, I hope you now have an understanding of all the different types of mutual fund metrics.

The following chapters will look into the evaluation of mutual funds and constructing a mutual fund portfolio for certain monetary objectives.

Stay tuned.

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