Up-capture: A different way of defining value-added in fund management
Jan 21st, 2010 | Filed under: Performance, Analytics & Metrics, Today's Post
We are accustomed to judging the value-added of investment funds in somewhat of a vacuum. That is to say, we do so without regard to our own judgments about where markets will go in the future. All that seems to really matter is the risk adjusted performance of a fund vs. its benchmark. If that benchmark goes up by, say, 10%, we hope our managers beat it by, say, 3%. If it goes down by 10%, we still hope to beat it by 3%. Despite the “absolute return” moniker conferred upon hedge funds, they too aim to simply beat their appropriate index, whether it be the HFRI convert arb index in the short term or the S&P 500 over the long run.
But a paper released last month by Brian Jacobsen (of Wells Fargo Funds Management – although the views expressed are Jacobsen’s) proposes a different way to looking at the value of active management. Instead of looking to traditional measures such as alphas and information ratios, Jacobsen looks at the up-capture and down-capture ratios of mutual funds to determine value-add.
He argues that investors buy mutual funds based on a given set of expectations about markets. If the investor thinks markets are going to rise significantly, she might seek out a fund with an out-sized up-capture ratio. Conversely, if she thinks markets will fall or remain flat, she might seek out a fund with a small down-capture ratio, regardless of the up-capture potential. In other words, the relative importance of historical up-capture and down-capture ratios will change depending on the investor’s expectations. As a result, writes Jacobsen,
“Depending on the investor’s expectations, a manager may be more or less valuable. Active management is, thus, context and investor dependent.”
He examines the up-capture and down-capture ratios of nearly 800 US equity mutual funds with a benchmark of the S&P500. Since no one knows the future direction of markets (or it would be priced in already), you’d expect investors to expect a 100% up-capture if they are expected to bear the burden of 100% down-capture (ignoring the effect of Prospect Theory for a moment). In fact, such a security would be the S&P 500.
But what if a fund had a zero down-capture ratio. In other words, what if the manager was really really good – like Madoff-good – at truncating their return distribution at zero and never losing money. What kind of up-capture ratio would an investor want in that case? Zero? That wouldn’t be much of an investment.
Using some basic assumptions made by Jacobsen, investors should – in theory – demand roughly a 25% up-capture ratio even in the presence of no apparent downside (red dots below – what he calls the “fair value” of the mutual fund as an “option”). But the 787 mutual funds he studied seem to have up-capture ratios that slightly exceed “fair value” (blue dots in chart below from paper).
By eschewing low downside for higher upside, investors are kind of saying “Security of low down-capture be damned! I want to ride this market up!” It’s as if greed trumps fear (could it be?)
This makes intuitive sense when you think about. Why assume any risk unless the upside is bigger than the downside.
Jacobsen calls the amount by which funds deliver greater than fair value up-captures an “investor surplus” (similar to the “consumer surplus” in economics). As of December 26, 2009, the average investor surplus, based on three year trailing data, was 0.026991 (i.e. the up-capture ratio delivered by mutual funds was, on average 2.7 percentage points higher than “fair value”).
The bottom line, according to Jacobsen, is one in which Wells Fargo – or any fund manager – may find solace:
“A manager can add value to a portfolio in ways besides just picking winning stocks—it is valuable to avoid holding a losing stock…Even if a manager does not beat a particular benchmark—which is a retrospective assessment—that does not mean that it was not—prospectively—valuable to invest with the manager.”
Related Posts
- Measuring the True Cost of Active Management by Mutual Funds
- Hedge fund databases capture 61% more funds than last year
- Are Hedge Fund Fees a Bargain? And Other Conundrums of Balancing Active & Passive Management
- Two studies find active management “put” was AWOL in 2008
- Active management redeemed?










Let’s say your active equity manager beats the index one month or one quarter. Fluke? Maybe so. How about a few months in a row or a few quarters in a row? The chance of them having horseshoes in their pockets becomes less likely as the number of months and quarters grows. But how many months does it take for you to know if your manager’s alleged “alpha” is truly alpha (i.e. skill) and how much is dumb luck. Furthermore, does this time horizon depend on the volatility of the fund itself?

Although hedge funds in general have displayed an uncomfortably high equity beta over the past year, there have been two bright spots – strategies that follow-through on the promise of low market correlation (and therefore, assuming returns are positive, alpha). Global Macro is one such category. Market Neutral is the other.
