After a decade filled with significant market declines and an increasing amount of volatility, it is safe to assume that many investors would like to find the best performing investment managers with the least amount of volatility. Today, if investing were compared to a roller coaster, it would be the scariest roller coaster that Great Adventure has to offer. However, many investors would be more comfortable with an investmentexperience more akin to the teacups at the county fair.

So, how can you fine tweak your investment portfolio to find investment managers that achieve good returns without participating too much in the downside during negative market periods? The answer may be easier to find than you think. A new statistic called “capture ratio” may be all you need to increase your odds of success.

The primary goal for most investors is to build a capital base with enough horsepower to pull them through retirement. As a result, many investors think they have to shoot for the highest rate of return in order to build the largest possible capital base. Investors fail to keep in mind that when you target higher rates of return, you may lose a significant amount of capital during unfavorable market periods. If you lose too much money, the markets may not recover enough to bail you out.

When investing, you should follow one simple rule. As long as I have capital, I will always be in great shape. Following this one rudimentary rule is easy. To achieve your primary goal, building a bigger capital base to pull you through retirement, you need to make sure you have capital. By minimizing losses during unfavorable market periods, it will take you less time to start making money when markets turn favorable. As a result, you should have a greater probability of increasing your capital base during good market periods. If you can repeat this theme over time, your portfolio will grow in value.

The statistic, capture ratio, is currently not published widely. However, it is extremely easy to calculate using two statistics, upside capture ratio and downside capture ratio, published at Morningstar.com. Before we delve further into the concept of capture ratio as a standalone and how to use it, let’s gain a firmer grasp on the two numbers used to calculate it.

Upside and downside capture ratios for mutual funds appear under the “Ratings and Risk” tab for each individual mutual fund at Morningstar.com. These statistics, offer a relatively straightforward way to evaluate a fund's historical performance during both rallies and down markets. In short, the statistics show you whether a given fund has outperformed--gained more or lost less than--a broad market benchmark during periods of market strength and weakness, and if so, by how much. When used in conjunction with other risk measures, upside/downside capture ratios can be a handy tool for monitoring your holdings' performance and conducting due diligence on possible additions to your portfolio.

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.

An upside capture ratio over 100 indicates a fund has generally outperformed the benchmark during periods of positive returns for the benchmark. Meanwhile, a downside capture ratio of less than 100 indicates that a fund has lost lessthan its benchmark in periods when the benchmark has been in the red. Typically, all stock funds' upside and downside capture ratios are calculated versus the S&P 500, whereas bond and international funds' ratios are calculated relative to the Barclays CapitalU.S. Aggregate Bond Index and MSCI EAFE Index, respectively.[1]

Here is an example of how upside and downside capture ratios work. If a mutual fund has an upside capture ratio of 100, then the mutual fund would achieve approximately 100% of the market’s upside. This means that when the market is up 10%, the fund would most likely be up 10% as well. On the other hand, if a mutual fund has a downside capture ratio of 70, then the fund would most likely capture 70% of the downside. As a result, if the market is down 10%, then the fund should have a negative return of approximately 7%. An investment manager that has an upside capture ratio greater than their downside capture ratio will tend tobuild capital more consistently over long periods.

To find managers that consistently gain more upside return than they do downside return, calculate managers’ capture ratio over one-, three-, five-, 10-, and 15-year periods. Here’s how you do it:

Upside Capture Ratio / Downside Capture Ratio = CAPTURE RATIO

A capture ratio of more than 1.00 indicates that a fund will generally outperform its benchmark index. The higher the number, the better off you will be. For example, a manager that has a capture ratio of 1.00 (upside capture ratio of 100 / downside capture ratio of 100 = capture ratio of 1.00) will most likely have a symmetrical correlation to the market. Where as, the manager who has an upside capture ratio of 100 and a downside capture ratio of 50 (100 / 50 = 2.00) will experience more upside with significantly less downside thereby building capital more consistently.

If you want to engineer a portfolio that will help you to build capital more consistently, you should calculate capture ratio before you look at any other metric. To illustrate the advantage capture ratio can provide, let’s take a look at two hypothetical portfolios.

The first portfolio, also known as “The Usual Suspects” consists of six commonly held mutual funds - two balanced, one bond, one dividend-focused stock fund, a domestic growth fund, and an EAFE growth fund. Each mutual fund is equally weighted in the portfolio’s allocation. The hypothetical investment portfolio began at the beginning of the 2000 bear market with a $1,000,000 initial investment.

Since 2000, “The Usual Suspects” portfolio performed quite well, posting a 6.76% annualized rate of return over the trailing 12-year period of the analysis, while the S&P 500 Total Return Index struggled to post a small positive return. During the bear market of 2000 to 2002, the portfolio grew the initial $1,000,000 investment to $1,094,107. It is important to note that the S&P 500 Total Index was down nearly 40 percent over the same period. The market bounced back from 2003 to 2007. During this time,“The Usual Suspects” improved from $1,362,586 to $2,057,187. However, in 2008, the portfolio declined 26.60% taking $2,057,187 to $1,509,936, a loss of $547,251. While the portfolio lost less than the market index, losses of 20% or more tend to cause investors to abandon their investment plan. The goal is to build a portfolio with components that improve loss protection without giving up much of the upside.[2]

In an effort to find mutual funds that met the criteria of gaining more and losing less, a spreadsheet was used to log the upside and downside capture ratios for each fund. The capture ratio was then calculated for each fund over the three-, five-, 10-, and 15-year periods. Many of “The Usual Suspects” met the criteria of achieving a capture ratio of 1.00 or more. However, there were several funds that did not achieve a capture ratio of 1.00 or more over each period. In addition, some of the funds inconsistently produced a capture ratio above 1.00. Several funds captured more downside than upside - some over multiple periods - and a portfolio that masters the art of capturing losses greater than the market is unwanted.

Using capture ratio exclusively, a modified portfolio was created –“Capture Ratio Maximized.” “The Usual Suspects” that did not achieve a capture ratio of 1.00 or higher over multiple periods were eliminated from the allocation. The allocation was then updated using funds in the same universe with capture ratios consistently higher than 1.00. The new “Capture Ratio Maximized” portfolio improved in multiple facets. Annualized rate of return increased from 6.76% to 7.68% and cumulative return increased from 121.62% to 146.21% percent. In addition, the portfolio’s worst down-market year, 2008, perks up from a negative return of 26.60% to negative 16.65%. The “Capture Ratio Maximized” portfolio may not generate as much upside return in good market years, but better downside capture ratio dynamics provided a larger capital base to start with in recovery periods.

From 2000 to 2002, the “Capture Ratio Maximized” portfolio grew from the initial $1,000,000 investment to $1,196,186. “The Usual Suspects” portfolio grew to $1,094,107. During the recovery period from 2003 to 2007, the portfolios ended with nearly the same capital balance, “The Usual Suspects” with $2,057,187 and “Capture Ratio Maximized” with $2,054,056. “The Capture Ratio Maximized” portfolio illustrates the potential loss protection benefits of performing capture ratio analysis by way of the market meltdown in 2008, ending the year with $1,712,091, a loss of -16.65%. The decreased participation in a down market yields a capital savings of $205,286 over “The Usual Suspects.” This capital savings gives the “Capture Ratio Maximized” portfolio significant edge leading into the recovery years. At the end of 2011, the “Capture Ratio Maximized Portfolio” finished with $2,462,078 versus $2,216,199 for “The Usual Suspects.”[3]

It is evident that reducing downside market capture can improve a portfolio’s dynamics greatly. Remember, this simplistic study focused solely on capture ratio to make investment decisions. Further due diligence could enhance these results even more drastically.

Capture ratio can help you create a portfolio that can aid in building capital more consistently over long periods of time. Keep in mind that capture ratio is based on the rate of return achieved relative to the market. As a result, instead of looking solely at return, as most investors do, capture ratio is one of the only statistics that is outcome oriented. In the future, resist the urge to employ the manager with the highest return and focus on building a portfolio that will achieve your investment goals using capture ratio.

**Matt Schreiber is President of Investments at WBI Investments and a Senior Investment Committee Member. WBI Investments manages $1.4 billion in absolute return strategies for income and growth. ****www.wbiinvestments.com **

[1]Upside & Downside Capture Ratio, Morningstar Investing Glossary, 2012, Morningstar, Inc., 5 Oct. 2012 http://news.morningstar.com/articlenet/article.aspx?id=374386

[2]Hypothetical Portfolio Illustration, Morningstar Principia, 2012, Morningstar, Inc., 27 Mar. 2012

[3]Hypothetical Portfolio Illustration, Morningstar Principia, 2012, Morningstar, Inc., 27 Mar. 2012