Capture ratio is a statistic that measures an equity's performance relative to some benchmark over a specific period of time. Upside capture ratio measures how well the equity "captures" the upside performance of the benchmark when it is rising, and downside capture ratio measures how well the equity "captures" the downside performance of the benchmark when it is declining.
Unlike complex statistics like Sharpe ratio and Sortino ratio, capture ratio is relatively straightforward and easy to understand. An upside capture ratio of 120 means that the equity gained 20% more than the benchmark when the benchmark was rising. A downside capture ratio of 80 means that the equity lost only 80% as much as the benchmark when the benchmark was declining. Or, to put it another way, the equity lost 20% less than the benchmark.
So for investors, the larger the upside capture ratio and the lower the downside capture ratio, the better.
Morningstar provides upside and downside capture ratios for ETFs on its Ratings and Risk page. Their glossary definition of these statistics is found here. Their methodology is described below:
"Upside capture ratios for funds are calculated by taking the fund's monthly return during months when the benchmark had a positive return and dividing it by the benchmark return during that same month. Downside capture ratios are calculated by taking the fund's monthly return during the periods of negative benchmark performance and dividing it by the benchmark return. Morningstar.com displays the upside and downside capture ratios over one-, three-, five-, 10-, and 15-year periods by calculating the geometric average for both the fund and index returns during the up and down months, respectively, over each time period."
Comparing these data for different investments can help individuals decide which choices are best for them. Someone who thinks stocks are going to rise will want an ETF with the highest upside capture ratio; someone who thinks stocks are going to fall will want one with the lowest downside capture ratio. Buy-and-hold investors will want an ETF with an upside ratio that is larger than its downside ratio. That way, their chances of gaining more on the upside than they lose on the downside will be increased.
The only drawback to using capture ratios is that they are not always calculated using the same benchmark. For Vanguard stock ETFs, Morningstar uses the S&P 500 as the benchmark. But for Vanguard's sector and international ETFs, Morningstar uses the MSCI World NR USD index as the benchmark. This means the capture ratios for the stock ETFs are not directly comparable to those for the sector and international ETFs.
Most Vanguard equity ETFs have only been in existence for about five years, so the following tables focus on five-year data (as of 5/29/12). ETFs in existence less than five years are omitted. The table shows each ETF's five-year upside and downside capture ratios, their difference (upside minus downside), and the ETF's five-year total return and standard deviation. The first table provides this data for thirteen Vanguard stock ETFs. The table is sorted by decreasing values in the difference column, and the most attractive values in each column are highlighted in bold.
HI DIV YIELD
For the highest upside capture ratio, the data show that small-cap stocks are the best choice. The three top ETFs in this regard are Small-Cap Growth (NYSEARCA:VBK), Small-Cap (NYSEARCA:VB), and Extended Market (NYSEARCA:VXF). By contrast, for the lowest downside capture ratio, dividend stocks are the best choice. The top two ETFs in this regard are Dividend Appreciation (NYSEARCA:VIG) and High Dividend Yield (NYSEARCA:VYM).
To find the best overall funds for buy-and-hold investors, the difference column subtracts the downside ratio from the upside ratio, and the results are sorted from highest to lowest. The two top ETFs, with almost identical difference values, are Small-Cap Growth and Growth. Both had five-year total returns of about 2.6%.
In my view Growth is the better choice because it is less volatile. It has a lower upside capture ratio than Small-Cap Growth, but also a lower downside capture ratio and one that is less than 100 (95.35). This means that Growth will decline less than the S&P 500 in down markets, which helps reduce anxiety when it looks like the sky is falling. It also has a lower five-year standard deviation than Small-Cap Growth, another sign of lower volatility.
For the most risk-averse buy-and-hold investors Dividend Appreciation is probably the best choice. Its upside capture is only 81.79, but it has the lowest downside capture ratio at 74.45. This means it only falls about three quarters as much as the S&P 500 in down markets. It also has the lowest five-year standard deviation of any of Vanguard's stock ETFs, which translates into lower volatility. The penalty it pays comes in the form of a lower five-year total return, 1.87%, compared to about 2.6% for the high-flying small-cap ETFs. But this may be a small price to pay for greater peace of mind.
The following table presents the same data for eleven Vanguard sector ETFs. Because Morningstar uses a different benchmark to calculate the data, the values here cannot be directly compared with the ones in the previous table.
For the highest upside capture ratio, REIT (NYSEARCA:VNQ), Materials (NYSEARCA:VAW), and Information Technology (NYSEARCA:VGT) are the best choices. All three have high volatility, as measured by their standard deviations. Information Technology has the lowest downside capture ratio of the three and the highest difference between the upside and downside values.
But the star of the show here is Consumer Staples (NYSEARCA:VDC) which has the lowest downside capture ratio by far and the second highest difference between the two ratios. Not only that, it has the highest five-year total return and lowest standard deviation in the list. For buy-and-hold investors it's the clear winner and best choice
The final table presents the same data for Vanguard's four international funds with five-year track records. These values are based on the same benchmark as the previous table.
ALL WORLD EX-US
For the highest upside capture ratio, MSCI Emerging Markets (NYSEARCA:VWO) is the clear standout. For the lowest downside capture ratio, MSCI Pacific is the only good choice. Judging by the difference between the upside and downside capture ratios, Emerging Markets is the clear winner. But its five-year total return is negative and its standard deviation is exceptionally high. From a buy-and-hold perspective, MSCI Pacific (NYSEARCA:VPL) may be preferable due to its lower volatility, despite its less than impressive five-year total return.
The bottom line is that upside and downside capture ratios are useful tools to help investors sort out funds that meet their needs from those that don't. From the perspective of the buy-and-hold retail investor, Vanguard Growth , Dividend Appreciation , and Consumer Staples appear to be the best ETFs of the bunch by far.
Disclaimer: I am not a registered investment advisor and do not provide specific investment advice. The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusions.