SuperInvestor.com.au

» Articles - A different way of defining value added in fund management

Up-capture: A different way of defining value-added in fund management

We are accustomed to judging the value-added of investment funds in somewhat of a vacuum.  That is to say, we do so without regard to our own judgments about where markets will go in the future.   All that seems to really matter is the risk adjusted performance of a fund vs. its benchmark.  If that benchmark goes up by, say, 10%, we hope our managers beat it by, say, 3%.  If it goes down by 10%, we still hope to beat it by 3%.  Despite the “absolute return” moniker conferred upon hedge funds, they too aim to simply beat their appropriate index, whether it be the HFRI convert arb index in the short term or the S&P 500 over the long run.

But a paper by Brian Jacobsen (of Wells Fargo Funds Management – although the views expressed are Jacobsen’s) proposes a different way to looking at the value of active management.  Instead of looking to traditional measures such as alphas and information ratios, Jacobsen looks at the up-capture and down-capture ratios of mutual funds to determine value-add.

He argues that investors buy mutual funds based on a given set of expectations about markets.  If the investor thinks markets are going to rise significantly, she might seek out a fund with an out-sized up-capture ratio.  Conversely, if she thinks markets will fall or remain flat, she might seek out a fund with a small down-capture ratio, regardless of the up-capture potential.  In other words, the relative importance of historical up-capture and down-capture ratios will change depending on the investor’s expectations.  As a result, writes Jacobsen,

    “Depending on the investor’s expectations, a manager may be more or less valuable.   Active management is, thus, context and investor dependent.”

He examines the up-capture and down-capture ratios of nearly 800 US equity mutual funds with a benchmark of the S&P500.  Since no one knows the future direction of markets (or it would be priced in already), you’d expect investors to expect a 100% up-capture if they are expected to bear the burden of 100% down-capture (ignoring the effect of Prospect Theory for a moment).  In fact, such a security would be the S&P 500.

But what if a fund had a zero down-capture ratio.  In other words, what if the manager was really really good – like Madoff-good – at truncating their return distribution at zero and never losing money.  What kind of up-capture ratio would an investor want in that case?  Zero?  That wouldn’t be much of an investment.

Using some basic assumptions made by Jacobsen, investors should – in theory – demand roughly a 25% up-capture ratio even in the presence of no apparent downside (red dots below – what he calls the “fair value” of the mutual fund as an “option”).  But the 787 mutual funds he studied seem to have up-capture ratios that slightly exceed “fair value” (blue dots in chart below from paper).



By eschewing low downside for higher upside, investors are kind of saying “Security of low down-capture be damned!  I want to ride this market up!”  It’s as if greed trumps fear (could it be?)

This makes intuitive sense when you think about.  Why assume any risk unless the upside is bigger than the downside.

Jacobsen calls the amount by which funds deliver greater than fair value up-captures an “investor surplus” (similar to the “consumer surplus” in economics).  As of December 26, 2009, the average investor surplus, based on three year trailing data, was 0.026991 (i.e. the up-capture ratio delivered by mutual funds was, on average 2.7 percentage points higher than “fair value”).

The bottom line, according to Jacobsen, is one in which Wells Fargo – or any fund manager – may find solace:

    “A manager can add value to a portfolio in ways besides just picking winning stocks—it is valuable to avoid holding a losing stock…Even if a manager does not beat a particular benchmark—which is a retrospective assessment—that does not mean that it was not—prospectively—valuable to invest with the manager.”

For more information, or to discuss your specific situation, please contact me directly.

Lisa Rivera
Director of Industry Relations and Outreach
Chartered Alternative Investment Analyst Association

Now that you have read this, what do you think?  Do you have other ideas?  Please share you views with other members (eg by blog or discussion form) and/or request professional member(s) to contact you directly.

 

Back

 

» Article Feeds

RSS Feed   Atom Feed