Question: Why isn't downside capture ratio a better measure of risk than standard deviation?
Answer: Risk can be defined in many ways (if you don't believe me, just click here), and consequently there are many different ways to measure it. The two metrics you mention are both very useful measures of risk, but they don't work in quite the same way. So let's take a closer look at each in order to understand what it tells us about a fund's performance.
Downside capture ratio measures how a fund has performed during market declines. It does this by calculating the extent to which the fund's performance mirrored that of its benchmark during months in which the benchmark lost ground. A ratio of 100 means the fund and benchmark lost an equal amount. If the ratio is higher, it means the fund lost more than the benchmark in those months and if it's lower, it means it lost less. So, lower is generally better because it suggests that during market downturns (as measured by the performance of the benchmark) the fund has lost less than the index.
Morningstar also calculates upside capture ratio, which measures fund performance relative to the benchmark for months in which the benchmark went up. A reading above 100 is desirable in this case. For more on the upside and downside capture ratios, which can be found under the Ratings & Risk tab on fund pages, read this Ask the Expert article.
Standard deviation is different in a few ways, not the least of which is that it measures the extent to which a fund's returns vary to both the upside and the downside as opposed to focusing on just downside variations. And in contrast with downside capture ratio, standard deviation does not compare a fund to its benchmark. Rather, it measures the volatility of the fund's own performance over a given time period. Technically, a fund's standard deviation -- found under the Risk/Rating tab in the Volatility Measures section -- reflects how far a fund's performance strayed from its overall average over a given time period. The higher the number, the broader the range of returns. Therefore, a fund with a lower standard deviation can be said to be less volatile while one with a higher standard deviation is considered more volatile.
Because this calculation is done the same way for all funds, without the use of an external benchmark determined by the type of fund in question, standard deviation is especially useful in gauging the volatility of funds relative to those of different types. For example, if you wanted to see how volatile a Canadian Equity fund is relative to a Global fixed Income fund, standard deviation provides an apples-to-apples comparison.
Why volatility matters
But, you may wonder, why pay attention to volatility if a fund that falls sharply is likely to rise just as sharply? The reason standard deviation is so important is because it can be predictive -- that is, a fund that has very high returns and high standard deviation may, at some point, also have very low returns. For example, Dynamic Power American Growth, which has the highest standard deviation among U.S. Equity funds (averaging 20.4 over the past decade), has gained at least 30% in four of the past 15 calendar years. However, on three occasions, it suffered double-digit losses, including a 44.1% walloping in 2008.
A high standard deviation often means an above-average downside capture ratio just as a below-average standard deviation often means a below-average downside capture ratio. But not always. Take, for example, Bronze-rated Fidelity True North 
, which has a 10-year standard deviation of 13.34, comparable to the Canadian Equity category average and the S&P/TSX Composite Index's. Yet, its downside capture ratio of 89.23 over that time period is well below the category average of 97.29. (Figures are as of Aug. 31.)
Another reason to pay attention to standard deviation is that funds that are more volatile are often harder to own -- that is, to hold on to through thick and thin -- than those that are less volatile. For example, a fund that gains 20% one year and loses 20% the next is more likely to see investors buy and sell at the wrong times than a fund that tends to deliver more stable returns. (This notion is backed up by Morningstar's Investor Returns data, which weighs fund flows against performance to determine the actual returns experienced by a typical investor in the fund.) To illustrate, consider that the average fund from the Emerging Markets Equity category -- typically among the most volatile -- has a 10-year standard deviation of about 18 while the average Canadian Short Term Fixed Income fund -- from a very docile category -- has a 10-year standard deviation of just 1.4.
And the winner is …
So, which metric -- standard deviation or downside capture ratio -- gives you the best sense of the downside risks associated with a fund? The good news is you don't have to answer that -- you get to use both. Use downside capture ratio to get a sense of how a fund might behave if its asset class hits a downturn. Use standard deviation to get a sense of how volatile its performance is likely to be over time. In both cases, compare its rating to the category average to get a sense of whether it's an outlier or close to the norm.
Be sure to also pay attention to the fund's Morningstar Risk rating, which incorporates elements of both these metrics. Funds are ranked relative to their peers with regard to the volatility of their returns, but downside performance is emphasized under the assumption that investors care more about sudden downward price movements than those to the positive side. (For more on how Morningstar Risk is calculated, click here.)
The point is to examine a fund's risk from different angles. The metrics mentioned here get at only a few of them, although they are among the most important. It's also a good idea to take a close look at a fund's portfolio to identify risks that may lurk but that have yet to manifest themselves, such as an unusually large allocation to a specific stock or sector. Reading the fund's most recent analyst report (provided it has one and you are a Premium Member) can also help alert you to hidden dangers.
No one fund metric can tell you everything you need to know before deciding whether to buy, hold or sell a fund. But looking at risk in various ways can help lead you to a clearer conclusion.Have a personal finance question you'd like answered? Send it to AskTheExpert@morningstar.com.
