Capture this: A simple, but useful tool for describing hedge fund returns

Retail Investing 06 Dec 2010

The hedge fund industry has an occasional obsession with exotic risk metrics (VaR, Conditional VaR, Omega Ratio, higher moments, etc.).  These make a lot of sense if you have a few Ph.D.’s on staff (read: you’re a large institutional investor).  But what if you need to explain the non-market-tracking nature of a hedge fund to a high net worth investor?  This, of course, is the daily challenge facing wealth managers.  Today, one of those managers, San Francisco-based Glenn Bossow of Belvedere Advisors, suggests a simple yet apt way to describe the performance of hedge funds.

Special to by: Glenn Bossow, Managing Director and Head of Investment Research, Belvedere Advisors

Selecting alternative investment managers is a task fraught with uncertainties and ambiguities for financial advisers.  To cut through this complexity and quickly evaluate a particular investment portfolio, we need the equivalent of an X-Ray machine that sifts through the data and reveals the skeletal features of the risk-return back-bone supporting the portfolio construction. Here’s a very simple device that creates an effective “spectroscopy” of a portfolio’s market exposure: the market capture spectrograph.

Capture Ratios

Study of human behavior dictates that investors focus on month-end returns and calendar year performance.  To most investors, the relevant evaluation of an investment is formulated in relation to the market’s performance over the same time period. The year of 2008, when the S&P 500 fell 38.5%, is seared into most investors’ memory. October 1987 and the Asian crisis of 1998 are other well-known periods of volatility.  In a particular month, the capture ratio is simply the ratio of the portfolio’s returns to the market returns:

Market Capture (Month N) = Portfolio Performance (Month N) /  S&P500 performance (Month N)

The “Up Market Capture” quantifies how much of the rise in the S&P500 a portfolio captures each month. The “Down Market Capture” quantifies how much a portfolio falls in months when the index has negative performance.

Suppose you found an investment that has some up and down performance during each calendar month, yet it ends each month with exactly the same performance as the S&P 500. In that case, the monthly Up Market Capture would be equal to 1 and so would the Down Market Capture since at each month end, whether the market is up or down, the investment has the same performance as the market. For such an investment, the Up and Down Market Capture histogram over time looks like the picture below (click to enlarge):

Each month in the chart is represented by one bar, whose size is equal to the market capture ratio. Since the market capture is equal to 1 for each month, all bars have the same height of 100%. The months when the S&P 500 was positive are represented by green bars and the months when the market was down are shown with red bars.

To enhance our appreciation for this type of spectrograph, let’s examine the Up and Down Market Capture since January 1996 of the Hang Seng Index, a proxy for Asian equity markets (shown in Chart 2).

Again, months when the S&P 500 was positive are represented by green bars and months when the market was down are shown with red bars. Note that the scale of the chart has been cut-off at +/-300%, which is sufficient for our purposes.

Most investors generally feel that their investment is performing “normally” when it returns positive performance in a month when the markets are up. This is characterized by upwards facing green bars in Chart 2; the market is up, and the portfolio consisting of the Hang Seng Index is up as well, so the ratio of the two performance numbers is positive. Conversely, green bars facing down represent months when the market was up, but the portfolio had negative returns since the bar represents the ratio of these two returns – the result is negative in that case.

In months when the markets are down, identified with red bars in the chart, the situation is reversed. If the portfolio is positive in such months, the red bar will be facing downwards since the ratio of the portfolio’s performance to the market’s performance is a negative number. Upwards facing red bars correspond to months when both the market and the portfolio are down, so that their performance ratio is a positive number.

Capture Frequency and Average Capture

The market capture spectrograph in Chart 2 yields a more detailed picture of an investment’s correlation to the markets than the correlation coefficient. For instance, the correlation coefficient of the Hang Seng Index relative to the S&P 500 is 65% over the period of time illustrated in Chart 2. However, the chart gives us an instant visual image that answers two related questions on which the correlation coefficient offers no insight:

  1. How often is the portfolio up when the markets are up, and down when the markets are down? In other words, what are the monthly Up and Down Market Capture frequencies?
  2. How much of the upside does the portfolio capture when the markets are up? Conversely, how much of the fall does the portfolio suffer when the markets are down?

In short, what are the average Up and Down Market Captures? The first question relates the number of desirable versus undesirable green and red bars in the chart. In Chart 2, the immediate impression is that there are many more green bars facing up rather than down (which is good) and similarly many more red bars up rather than down (which is not desirable). A simple count of these bars being up or down reveals that the market capture frequencies for the Hang Seng Index are as follows: Up market capture frequency = 81%, Down market capture frequency = 77%.

As always, these are long-term statistics that are meant to give investors a feel for an investment’s likely behavior relative to the markets. These methods and their results are just part of a vast set of tools that investors must use to develop an appreciation for the multiple facets of risk present with any investment.

Market Capture Example (Long/Short)

Consider the performance track record presented below for a fictitious long/short equity fund that launched in August 1996:

What new observations can we make now that were not obvious from simply looking at the performance track record in the chart above? How about:

  1. The ability of the strategy to generate positive returns when the market is up is impressive. With a 98% up-capture frequency, most green bars (market up months) are upwards, and the few downward pointing green bars are relatively short.
  2. The strategy is able to capture far more of the market upside (27%) than it loses when markets fall due to its 4% down-capture. This asymmetry is important to increase the consistency of returns.
  3. This strategy feels highly defensive overall . It captures on average only about a quarter (27%) of the S&P 500 monthly rise. Intuitively, the “remaining” 73% potential upside in the S&P 500 is what the strategy gave up to protect itself against market falls.
  4. The fact that this strategy is defensive could have been inferred from its 2008 performance of -2.6%. There are long periods where the strategy dials down risk to very small levels, such as January 2002 through August 2003, or January through September 2010. During these periods, the strategy makes little money, but it also does not risk losing significant principal. At other times, for instance from June 2005 through October 2007, the strategy increases its risk taking and therefore its Up and Down Market Capture each month.

Market Capture Example (Global Macro)

Now consider now the performance track record presented below; the strategy launched in January 1999 and trades listed equities around the world are based on a largely automated quantitative methodology.

Once again, these simple charts and statistics lead us to several insights that can be used in due diligence conversations with the fund manager or in comparing this strategy with others. For instance:

  1. Comparing this capture chart to the last one, you can see that the strategy seems to make money when the markets are down. In the previous chart, there were relatively few red bars pointing down and their average size was small; in this one, there are many down red bars of significant size, many of them exceeding the scale of the chart.
  2. The average down capture is -62%.  By contrast, the mutual fund down capture was +4% in the first example, which means that, on average, that fund lost money in months when the market was down.
  3. The year 2010 repeats a pattern that we have witnessed across a vast number of investment strategies: This year is clearly a period of reduced risk taking, as shown by the relatively small size of the Up and Down Captures. This is consistent with the behavior of the equity markets, the S&P 500 having experiences more monthly swings of +5% or -5% this year than almost any year since the 1930’s. The strategy has correctly spotted a difficult period in the markets and been useful in scaling back risk.

Up and Down Market Capture statistics and histograms are one of the many tools at investors’ disposal to evaluate the risk return characteristics of investment opportunities. As illustrated by the two alternative investment strategy examples above, developing a feel for these statistics enables investors to make insightful observations about the past and to extrapolate what may be relevant for the present and future.

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  1. Gabe
    December 7, 2010 at 1:18 pm

    Caution: The up/down capture ratios can be deceiving if the nominal numbers involved are small. For example, if you look at the S&P 500 Index return in December 2005, +0.03%, and a manager returned +3.00% during this up market period, the manager’s up market capture ratio would be 10,000.

    Is there an appropriate way to deal with anomalies like the above example?

  2. John R. Graham
    May 18, 2011 at 6:42 pm

    It’s easy to follow, for sure, and that is good. However, I don’t think you’re capturing alpha, but up-beta and down-beta. Am I understanding your technique right?

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