Select Funds Can Reduce Risk
Index funds fall as far as the market they track, but investors don’t have to. Over time they can gain more by losing less.
Gain by Losing Less
There are two ways to beat the index and fuel investment growth – earn more than the market or lose less than the market.
Losing less – the so-called low-downside capture approach – holds appeal for investors. Especially considering that 78% of them list protecting assets as their top investment priority but only about half are aware that index funds expose them to 100% of market downturns.
A fund’s downside capture ratio is an indication of whether a fund has lost more or less than the market during periods of market weakness. For example, if over the course of a downturn a fund fell only 96% as far as the market, its downside capture ratio is 96%. If it fell 5% more than the market, its downside capture ratio is 105%.
Why It Matters
Consistently losing less during downturns can be instrumental in producing larger balances and superior outcomes for long-term investors. Funds that limit downside risk tend to also provide a smoother ride, making it easier for those with long-term objectives to stay the course during turbulent markets.
The Arithmetic of Loss
The ability to achieve superior outcomes by losing less is an example of what’s known as the arithmetic of loss. Consider the following:
If a $1,000 investment loses 50%, its value drops to $500. In order for the investment to return to the $1,000 level, that $500 must do more than gain 50% (which would only bring it to $750); it needs to double.
Digging out of a hole is never easy, but the shallower the hole, the shorter the climb.
Better Positioned by Losing Less
The farther an investment falls, the longer the path back to break even. Some funds offer the potential to hold on to more of one’s investment during market declines which leaves investors better positioned for a rebound.
To Mitigate Risk, Seek Funds That Have Held Up Better During Declines
Looking at a fund’s downside capture ratio — a comparison of how far it has fallen relative to its index during downturns — is one way to evaluate its riskiness.
When we added downside capture to two other screening criteria — low expenses and high levels of manager investment — we uncovered a group of funds that has, on average, delivered index-beating results.
Finding Funds That Can Mitigate Risk
Within the universe of Large Cap U.S. funds, screening for funds with downside resilience — funds that capture less of a market decline than the index — results in a lower risk group that, on average, outpaced its peers as well as the S&P 500 Index.
Further narrowing the low-downside group using low expenses and high manager ownership as additional screening criteria increased the advantage over the index and reduced risk further. The chart shown here is based on data for rolling five-year periods for the 20 years ended December 31, 2015.