Capture Ratios and Drawdowns in Manger Evaluation

Capture and drawdown ratios aid clients in evaluating a manager's suitability. For instance, a retiree seeking a safe and conservative investment manager may prefer avoiding those with frequent, substantial drawdowns. In contrast, a young, risk-seeking investor might be more tolerant of these drawdowns if they offer the potential for higher returns.

Important Ratios

1. Upside Capture Ratio (UC): UC measures how well a portfolio performs when the benchmark has positive returns. UC > 100% suggests outperformance compared to the benchmark.
2. Downside Capture Ratio (DC): DC measures how well a portfolio performs when the benchmark has negative returns. DC < 100% suggests outperformance compared to the benchmark.
3. Capture Ratio (CR): CR is UC divided by DC, indicating return asymmetry. CR > 1 signifies positive asymmetry or a convex return profile, while CR < 1 indicates negative asymmetry or a concave return profile.
4. Drawdown: Drawdown is the total loss from a peak to a trough during a specific time frame.
5. Drawdown Duration: Drawdown duration is the time from the start of a drawdown until cumulative losses recover to breakeven.

We'll discuss how to interpret these ratios in the following section of this reading. When calculated correctly, they provide valuable insights into the investment manager selection process.

Interpretating Ratios

$$ \begin{array}{c|c|c|c}
\textbf{Profile} & \textbf{UC} & \textbf{DC} & \textbf{CR} \\ \hline
\text{Long Only} & 100\% & 100\% & 1.0 \\ \hline
\text{Positive asymmetry Portfolio} & 75\% & 25\% & 3.0
\end{array} $$

In the table above, we see the use of the capture ratio. The long-only portfolio is entirely invested in FTSE 100 equities. The positive asymmetry portfolio, however, allocates 80% to FTSE 100 equities during strong market periods and 20% during weak ones. The remaining portion is in low-yielding AAA corporate bonds.

The long-only portfolio, by design, mirrors 100% of the stock index's ups and downs, resulting in a capture ratio of 1.0. In contrast, the positive asymmetry portfolio benefits from market timing and asset class allocation, capturing 75% of the FTSE's gains and only 25% of its losses, yielding a capture ratio of 3.0.

Opting for a low-beta portfolio to limit drawdowns can be advantageous. While no portfolio can surpass the positive asymmetry portfolio in terms of performance, a low-beta portfolio, due to the geometric nature of returns, might even outperform the long-only portfolio, albeit with lower returns.

Drawdowns serve as stress tests for the investment process, revealing potential flaws, inadequate risk controls, or operational issues. A manager's response to significant drawdowns and the lessons learned provide insights into the robustness of the investment, portfolio construction, and risk management processes, as well as the effectiveness of those implementing the investment system.

Active Share

Active share measures the difference in portfolio holdings relative to the benchmark. A manager that precisely replicates the benchmark will have an active share of zero; a manager with no holdings in common with the benchmark will have an active share of one.

$$
\text{Active Share} =\frac {1}{2} \sum {|\text{Strategy weight} – \text{benchmark weight}|} $$

Active share is related to tracking risk, and can be used in conjunction with many of the previously mentioned drawdown and capture ratios. The following table demonstrates the effects of combining certain degrees of active share and tracking risk and the portrait of the manager, which is subsequently painted.

$$ \begin{array}{c|c|cc}
& & \textbf{Active Share} & \\ \hline
& & \textbf{Lo} & \textbf{Hi} \\ \hline
\textbf{Tracking} &\text{Hi} & \text{Sector Rotator} & \text{Concentrated stock picker} \\
\textbf{risk} & \text{Lo} & \text{Closet indexer} & \text{Diversified stock picker}
\end{array} $$

Question

A manager with a high active share and high tracking risk is mostly appropriately classified as a?

1. Diversified stock picker.
2. Concentrated stock picker.
3. Sector rotator.

Solution

The correct answer is B.

A manager with a high active share and high tracking risk is most appropriately classified as a “concentrated stock picker.” This manager is actively selecting a relatively small number of stocks that differ significantly from the benchmark index. Their portfolio will have a high tracking risk because it doesn't closely track the benchmark, and a high active share because they are making distinct, concentrated bets on a limited number of stocks.

A is incorrect. A manager with a high active share and high tracking risk is not accurately classified as a “diversified stock picker.” Diversified stock pickers typically aim to create portfolios that closely resemble a benchmark index, meaning they have low active share and low tracking risk. They seek to mimic the overall market or index rather than deviating from it significantly.

C is incorrect. A sector rotator is a type of manager who frequently changes their portfolio allocations among different sectors or industries. This may or may not be related to their active share or tracking risk. The terms “sector rotator” and “concentrated stock picker” refer to different aspects of portfolio management.

Performance Measurement: Learning Module 2: Investment Manager Selection; Los 2(d) Describe uses of the upside capture ratio, downside capture ratio, maximum drawdown, drawdown duration, and up/down capture in evaluating managers