In some analyst’s eyes Tracking Error, which measures how closely a fund follows its benchmark index, provides a useful way of measuring both a fund's performance, and value against the index. It is calculated as the standard deviation of the difference between the returns of an investment (or fund) and its benchmark. The theory is that the more active the fund the higher its performance should be compared with the benchmark, and therefore the higher its tracking error should be. Conversely, the lower the Tracking Error, the more closely the fund follows the index. The logic seems straightforward enough: Investors in active funds, and paying “active” fees, don’t want to pay the fund manager to simply track the index.
Unfortunately, the Tracking Error can be a misleading way to evaluate a manager’s performance.
A more informative way to look at a fund’s performance vs its underlying benchmark or index is to measure its Up and Down Capture Ratio. Once understood, they provide a more realistic measurement of a fund's ability to perform in both positive and negative markets.
The up capture ratio shows the percentage of the market’s gains the fund has captured when the market rises. The higher the up capture ratio, the better the fund has performed in positive markets. Conversely, the down capture ratio shows the percentage of the market’s losses the fund captures when the market falls. The lower the down capture ratio, the better the fund’s performance in negative markets.
So far so good! However, selecting funds based on their relative up and down capture ratios will also be dependent on the investor’s circumstances (age, life cycle), risk tolerance and one’s market expectations.
Down Capture is particularly useful as it indicates the fund’s ability to protect capital in falling markets. If an investment loses 20% it needs to gain 25% just to get back to where it started, and if it loses 40%, it needs a return of 66.7% to get back to even.
As an example, the Collins St Value Fund and the DS Capital Growth Fund both appear in their peer group’s highest performance quintile over 3 and 5 years. This is primarily based on their low down capture ratios of 47.6% and 70.5% respectively. Similarly, the Bennelong Australian Equities Fund was also in the highest performance quintile but based on a high up capture of 131.7%. Importantly both DS Capital and Bennelong had low tracking errors compared to the respective peer group. The L1 Capital Global Opportunities Fund returned an impressive 35.51% per annum for the past 5 years by not having a negative return in any month, resulting in a negative down capture ratio of -131%, while also having a relatively low Tracking Error of 11.5.
For most Advisers and Investors, it is easy to get lost in a sea of often contradictory statistics that potentially don't tell the full story. It is better to have a high level of diversification, and to concentrate on those statistics that are aligned to your investment goals - whether that be protecting the downside, or making hay while the sun shines!
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