Question: In their reports, Morningstar analysts often talk about a fund's upside and downside capture ratios. What do those statistics mean?
Answer: This set of statistics, which appear on the "Risk/Rating" tab for each individual fund, offer a relatively straightforward way to evaluate a fund's historical performance during both rallies and down markets. When used in conjunction with other risk measures, upside and downside capture ratios can be handy tools for monitoring your holdings' performance and conducting due diligence on possible additions to your portfolio.
How are the ratios calculated?
The term "upside/downside capture ratio" might sound wonky, but the concept is pretty straightforward. 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.
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.ca displays the upside and downside capture ratios over one-, three-, five-, 10- and 15-year periods by calculating the geometric average for both the fund and index returns during the up and down months, respectively, over each time period.
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 less than its benchmark in periods when the benchmark has been in the red. The benchmark used to determine the ratios is determined by the fund's category and is indicated right below the table. For some context, we also show the category average upside/downside capture ratios for those same time periods.
What do the numbers mean?
If both the upside and downside capture ratios for a fund are 100, that means the fund moved in lockstep with the benchmark during both up and down markets. For example, index trackers like TD Canadian Index show upside/downside capture ratios that are just a hair away from 100. (The funds' expense ratios are the main reason they don't track the benchmark perfectly.)
But for most actively managed funds, upside and downside capture ratios will illustrate a more significant divergence from the benchmark. For example, Mawer Canadian Equity 
has a three-year upside capture ratio of 96.34% and a downside capture ratio of 19.74%, which indicates that it nearly matched the S&P/TSX Composite Index in up markets but "captured" only about 20% of its benchmark's negative performance during market declines. Such a strong record of upside potential coupled with downside protection means the fund is a worthwhile candidate for further investigation.
Keep in mind the caveats
While Mawer Canadian Equity demonstrates a "best of both worlds" performance pattern, most funds will have a bigger trade-off between their upside and downside performance. If a fund has a sizable up-market performance versus its index, it is likely to have subpar downside performance, and vice versa.
Moreover, it's worth bearing in mind that all funds within a given category are compared to a single market benchmark. For example, we use the S&P/TSX Composite for Canadian Equity funds, the S&P 500 for U.S. Equity funds, the MSCI EAFE for International Equity funds, and the Bank of America Merrill Lynch Canada Broad Market Index for Canadian Fixed Income funds. If the manager uses an investment style that's dramatically different than the benchmark, you can expect that its upside/downside capture ratios will be striking.
Take National Bank Monthly Secure Income, for example. Because its interest-rate sensitivity is much more muted than that of the BofAML Canada Broad Market Index, its upside/downside capture ratios show that it has strongly underperformed the benchmark when the index has generated positive returns while dramatically outperforming it on the downside. In such situations, it can be useful to compare the fund's upside/downside capture ratios versus the benchmark with those of other funds that share a similar strategy.
