highly volatile portfolio?€¦ · and bad markets can be your best ally. as we’ve all heard, a...

benefits magazine november 20122

Highly Volatile Portfolio?

Take Control

A capture ratio is a statistic trustees can use to help choose and monitor pension fund

investment managers. The author explains how to use this often-overlooked tool.

november 2012 benefits magazine 3

If you are a trustee for a defined benefit plan, strategies that perform consistently in good and bad markets can be your best ally. As we’ve all heard, a well-balanced portfolio is the key to weathering the storms of volatile markets. Some plan sponsors and trustees thought their portfolios were well-diversified and yet seemed to be taking two steps back for every one step forward. This can be a frustrating feeling with seemingly no way to

correct it.This article discusses an important yet sometimes overlooked statistic trustees can use to

help minimize volatility and begin to turn things around.The problem may not be with the pension fund’s asset allocation. It may instead be with the

way the fund hires and pieces together its team of money managers. While a manager’s perfor-mance is important, it is more important that trustees dig a little deeper—and don’t chase the hottest thing or the latest fad. An example of turning an increasingly volatile situation into a more stable, productive and diversified portfolio follows.

Too many times, trying to play “catch-up” has cost a plan more than it has helped. In many cases, managers that perform abnormally well on the upside (when the market is generally up) show the same volatile tendencies on the downside (when the market is down). After a good quarter, the trustees leave their performance review meetings extremely pleased with the results, only to be devastated after the next negative quarter.

The endless cycle of ups and downs that the market has experienced over the past decade has taken its toll on many plans, trustees and participants.

by | Dennis W. Schilling

Highly Volatile Portfolio?

Take Control

Reproduced with permission from Benefits Magazine, Volume 49, No. 11, November 2012, pages 42-47, published by the International Foundation of Employee Benefit Plans (www.ifebp.org), Brookfield, Wis. All rights reserved. Statements or opinions expressed in this article are those of the author and do not necessarily represent the views or positions of the International Foundation, its officers, directors or staff. No further transmission or electronic distribution of this material is permitted. Subscriptions are available ) www.ifebp.org/subscriptions).

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volatile portfolios

One tool that can help trustees take control of the fund’s portfolio is the capture ratios. This tool is far from being the only statistic and data used when evaluating investment manag-ers and portfolios and trying to reduce some of the manic swings a portfolio has experienced. But the capture ratio is a tool that often is overlooked.

The definitions, figures, tables and a summary included in this article show generic applications and strategies. Like most of the readers of this article, our goal is to attempt to achieve the highest possible return with the least amount of risk. Because many defined benefit plans have a return target of approxi-mately 8%, the information in this arti-cle is presented with that target in mind.

Market Capture ratioA market capture ratio is a statisti-

cal measure of an investment manager’s performance in up and down markets. The up-market capture ratio is used to evaluate how well an investment man-ager performed relative to an index dur-ing periods when that index has risen. The ratio is calculated by dividing the manager’s returns by the returns of the index during the up market, and multi-plying that factor by 100. (See Table I.)

The down-market capture ratio is used to evaluate how well an investment manager performed relative to an index during periods when that index has fall-en. The ratio is calculated by dividing the manager’s returns by the returns of the index during the down market, and mul-tiplying that factor by 100. (See Table II.)

Using Capture ratios to Help take Control

You can begin by evaluating your current managers’ capture ratios. Most

TABLE IIIManaged Capture Ratio Portfolio vs. S&P 500 110.0 Up Capture/ 85.0 Down Capture 100.0 Up Capture/ (simulated managed 100.0 Down Capture S&P 500 capture ratio) “The Market” $1,000,000 $1,000,0002008 237.48% $681,700 231.86% $625,500 237.48%2009 27.67% $889,209 30.44% $798,600 27.67%2010 15.06% $1,036,463 16.56% $918,900 15.06%

Note: This is a hypothetical example and is not representative of any specific investment. Your results may vary. All indexes are unmanaged and may not be invested into directly.

TABLE IUp-Capture Ratio Examples Example 1 Example 2 Example 3Index +10% +10% +10%Manager +10% +11% +9%Up-Capture Ratio 100% 110% 90%

TABLE IIDown-Capture Ratio Examples Example 1 Example 2 Example 3Index 210% 210% 210%Manager 210% 211% 29%Down-Capture Ratio 100% 110% 90%

FIguRE 1Managed Capture Ratio vs. the Index (S&P 500)


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Managed Capture Ratio Portfolio

Market Index

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volatile portfolios

consultants have the ability to run capture ratios on all money managers that report to the major databases. Not only can they provide this for each of your money managers, they can pro-vide this for your “total portfolio” vs. a policy benchmark or blended index that best represents a comparison for your plan.

You should make sure this is done during the screening for each new man-ager search. Review capture ratios as an important performance characteristic before selecting a money manager.

How Capture ratios Make a Difference

Your total portfolio will be com-prised of various types of managers with different volatility and perfor-mance characteristics. Your fund must achieve an overall up-capture ratio higher than its down-capture ratio or you are playing a losing hand. Over time, this will help dramatically dur-ing sharp down periods like the end of 2008/early 2009, while allowing for the rebound such as the one that occurred in 2009-2010.

The hypothetical illustration in Table III and Figure 1 shows the ben-efit of managing capture ratios through the downfall of 2008. This allowed the portfolio to rebound beyond its break-even point much more quickly than the market. Some portfolios with a poor downside capture ratio are still trying to recover from the market disaster of 2008.

Though downside protections can be greater, you can see that having “some” downside cushion and los-ing less in 2008 provided more capital when the market rebounded. Although both portfolios grew in 2009 and 2010,

the advantage was given to the port-folio that protected the most on the downside during the 2008 downturn.

ApplicationA client’s case helps illustrate this.

The fund’s current large-cap growth manager has performed well but the trustees are looking to reduce the amount of volatility this manager has produced for the plan. While this in-vestment manager has assisted the

FIguRE 2Five-Year Quarterly Performance—Ending 6-30-2012 Manager A (Current Manager) vs. Russell 1000 Growth Index

Note: This is a hypothetical example and is not representative of any specific investment. Your results may vary. All indexes are unmanaged and may not be invested into directly. Past perfor-mance is not a guarantee of future results.

Manager A R1000G Index

Arrows indicate down-market underperformance of Manager A(Current Manager) or high down-market capture ratio.

Up-market performance has been very good.

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FIguRE 3Five-Year Quarterly Performance—Ending 6-30-2012 Manager B (Potential Candidate/Addition) vs. Russell 1000 Growth Index

Note: This is a hypothetical example and is not representative of any specific investment. Your results may vary. All indexes are unmanaged and may not be invested into directly. Past perfor-mance is not a guarantee of future results.

Arrows indicate good down-market performance or low down-market capture ratio.

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Manager B R1000G Index


volatile portfolios

plan’s high ranking in the Taft-Hartley universe during good markets, the manager has also been a drag on per-formance during down markets. The five-year performance of Manager A (current manager) is shown in Figure 2, indicating that Manager A has con-tinued to increase its downside capture

over the last four down periods. The positive characteristic about Manager A is that the manager also has main-tained its above-average upside cap-ture. The next step is to find a manager that would blend well with Manager A to moderate the downside volatil-ity while not dampening the upside

dramatically. This will not only help to smooth out performance but should provide additional diversification to the overall portfolio.

Figure 3 illustrates the dampen-ing effect Manager B provides on the downside. Let’s now take a look at a competing “growth of a Dollar Chart of Manager A vs. Manager B.” The two managers end up near the same desti-nation but took very different routes to get there. (See Figure 4.)

Now another quality manager (Man-ager B) has been identified. Manager B performs, longer term, as well as Man-ager A, with performance characteristics that help reduce the downside volatility without potentially harming the longer term upside potential. This combination of managers should help smooth out the overall volatility experienced in the large-cap growth allocation of the port-folio. Figure 5 shows the combined per-formances of Managers A and B.

Figure 5 shows that by combining Manager A and Manager B, the down-side capture ratio has been reduced. The large-cap growth sector of the portfolio is now poised to outperform its relative benchmark and better positioned to preserve capital in falling markets.

Another benefit this exercise has provided is diversification for the to-tal portfolio. Manager A and Manager B, though both considered large-cap growth managers, have contrasting styles that allow them to react differ-ently to ever-changing market condi-tions. Manager A manages to a style that seeks quality growth in earnings, which historically responds well to a stable and upwardly moving markets. Manager B buys stocks that show the greatest potential to grow their divi-dend. This style historically does well

FIguRE 4Manager A vs. Manager B Five-Year Growth of a Dollar (Quarterly) Ending 6-30-2012 Illustrating Differences in Volatility Characteristics


$1,500$1,400$1,300$1,200$1,100$1,000$900$800$700$600

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FIguRE 5Combining the Talents of Managers A and B vs. A to Manage Downside Volatility


Combo A and B Manager A

Underperformance for each down-market periodhas been reduced vs. using only Manager A

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learn more >>EducationTrustees and Administrators Institutes February 18-20, 2013, Lake Buena Vista (Orlando), FloridaFor more information, visit www.ifebp.org/ trusteesadministrators.Investments Institute April 22-24, 2013, Phoenix, ArizonaFor more information, visit www.ifebp.org/investments.

in volatile and downward-moving markets. given the quality of the managers and their contrasting styles, this combination should work well for the fund in the unpre-dictable markets ahead.

While it is important to evaluate capture ratios when per-forming an initial manager search, it is equally important to continually monitor these ratios by having them as part of your quarterly performance review.

Where Do We Go From Here?Many call 2000-2010 the lost decade. There was a lot of

movement in the market but the general indexes ended up going nowhere. This is where good management and strate-gic oversight really helped.

using capture ratios, along with sound asset allocation measures, an in-depth understanding of your investment managers and their investment philosophies, and regular performance monitoring will go a long way toward achiev-ing a fund’s goals.

using capture ratio analysis is one way to give your port-folio some built-in downside cushion to help protect against the violent downturns, like those seen in 2008. Any protec-tion of capital during violent downturns will provide that much more of a benefit when things correct to the upside.

Author’s note: There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not protect against market risk. No strategy can ensure a profit or pro-tect against loss. Investing involves risk, including the pos-sible loss of principal. The opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All indexes are unmanaged and may not be invested into directly.

takeaways >>• Often, managers that perform abnormally well when the market is

generally up show the same volatile tendencies when the market is down.

• Trying to play catch-up with pension fund investments can cost a plan more than it helps.

• Having investment managers with contrasting styles can not only help a fund through volatile market periods, but also provide better diversification.

• Capture ratios should be monitored as part of quarterly performance reviews.

Dennis W. Schilling is president of Schilling Investment Consultants in Nashville, Tennessee, which focuses on working with Taft-Hartley plans nationwide. He has worked for more

than 26 years as an investment consulting advisor to trustees, investment committees and plan sponsors, and in 1985 helped create the invest-ment consulting services group for a large southeastern regional investment firm. Schilling previously worked in banking and marketing. He studied business and finance at the university of Tennessee at Martin and union university.

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highly volatile portfolio?€¦ · and bad markets can be your best ally. as we’ve all heard, a...

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