Funds that withstand downturns better tend to yield higher returns

 

The current slump in the stock market, after a sustained upward march for close to two years, has caught several equity funds on the wrong foot. The current situation proves a fund should not be judged merely by its performance when the broader market is on a roll. What makes a fund a solid bet is its performance when the chips are down. Funds that withstand downturns better tend to yield higher returns over the long term. Very few funds boast the ability to deliver returns higher than the market during a bull phase, while limiting losses during a downturn. These funds emerge as the outperformers over time.

To test this argument, we considered the up and down capture ratios of different categories of equity funds from September 1, 2010 to August 31, 2015, a period when funds had to handle varied market climates. The ratio shows how much of the market's move was captured by the fund. The upside capture ratio indicates the percentage of the market's gain that was captured by the fund while the downside capture ratio reveals the percentage of the market's fall that was captured by the fund. So, while an upside capture of over 100% indicates that a fund outperfor med the benchmark or category average during periods of positive retur ns, a downside capture below 100% indicates that a fund lost less than its benchmark or category average during periods that the market was in the red. For instance, if during a period, the market moved up by 20%, but the fund moved up by 25%, it means that the fund captured 125% (25% of 2 0 % ) o f t h e m a rke t 's m ove.Similarly, if the market went down by 10% and your fund value drops by 8%, the fund would have a downside capture of 80%.

Each fund's performance has been compared with its respective benchmark index.

The data provided by Morningstar India shows that over the past five years, the funds with a lower downside capture ratio have emerged among the top performers.

Across categories, funds that have limited the downside well have fared better than their category average. These funds have stood out over this 5-year period because it was a time when the markets went through significant ups and downs. For instance, in the large-cap space, funds with a downside capture of less than 100% yielded annualised return of 10.23% on average in the 5 year period, compared to the category average of 9.61%. On the other hand, funds that captured more than 100% of the market downside during this period averaged retur n of 6.67% only.Many of the funds with a high downside capture boast of more than 100% upside capture. They generated higher return than the market during periods of price rise--yet lost out ultimately owing to the bigger hit taken during downturns. Similarly, in the mid-and-small cap category , funds with a downside capture of more than 100% averaged annualised return of 7.37% over the 5 years against the category return of 16.32%. In contrast, funds that kept the downside in check delivered 17.13% annualised return. SBI Small & Midcap Fund, for instance, only captured 91% of the market upside during these 5 years, but its extremely low downside capture helped it be a table-topper.

Funds which suffered from high downside capture were among the best in terms of upside capture, but lagged behind other funds over the entire time period. The same trend is visible in the flexi-cap space. It is clear from this analysis that investors would do well to side with funds that are adept at providing a buffer against market declines and not those which give the highest returns when the going is good. While managing downside well is critical, the fund should have a decent upside capture as well, even if not among the highest.

Long term performance boils down to how the fund manages the downside. Even if the fund boasts of the ability to capture 140% of the market upside, but sees similar value erosion during downturns, it will not come out healthy over time.

However, this doesn't mean that the fund's ability to ride a market rally should be overlooked.