Benefits of Optimizing Portfolio Capture Ratios

The world of investing has changed dramatically. Over the past decade, many investors have discovered that conventional passive growth stock approaches failed to meet their goals. Following a buy-and-hold approach, investors suffered losses of as much as 51% during the 2000 through 2013 period.[1] We believe conventional portfolio theory regarding the benefits of diversification has been broadly misinterpreted to mean that market returns will bail you out, and so investors should not worry about short-term losses. But in reality, typical market losses like these can make it difficult for investors to fund their retirement sufficiently, and may cause them to outlive their stream of income.

In 2008, many investors found that traditional approaches relying on diversification to reduce risk failed them. Portfolio management strategies which were generally considered sound faltered. The markets defied the tenets of covariance and diversification and many asset classes declined precipitously across the board. Conventional portfolio construction theory has held forth the notion that asset diversification reduces risk. We believe investors have misunderstood this, interpreting it to mean that diversification protects capital. While diversification can reduce total risk if the correlation among the portfolio assets is low, we feel the real problem is that in periods of market turmoil, the low correlations evaporat Riske as many assets move down together. Therefore, just when you need the risk-reducing benefits of diversification the most, they actually disappear, and capital is lost rather than protected.

We feel investment allocators need to develop a process to find managers who have demonstrated ability over time to protect capital from severe losses in bear markets while capturing good returns in bull markets. Such ability may be confirmed using capture ratio statistics. To meet the “acid-test”, investment approaches must work in both good and bad market cycles. We believe that today more than ever, investors need to develop better allocation and manager selection approaches to replace the risk benefits of diversification to improve their odds of building capital more consistently. Capital preservation in bear markets can be far more important to achieving success than chasing the highest returns during bull markets.

We believe investors need to replace antiquated diversification risk-reduction strategies with a more capture-ratio-oriented approach to find managers who have demonstrated the ability to provide the desired blend of return and risk management based on client risk profiles. Selecting managers who have historically demonstrated performance with a desirable blend of up and down-market capture ratios should allow investment allocators to develop portfolio allocations that will allow investors to stay more comfortably invested for the long run, and especially when markets turn bearish.