Last Updated on March 14, 2020 at 2:19 pm
Every time the market falls, investors tend to compare the fall in their active funds and indices. They expect their funds to fall less than the “market” every time or at least every time they bother to look. It is incorrect to take two random dates and claim either active mutual fund fall less, more or just as much as the indices. In this article, I explain how to define this so-called downside protection and if active mutual funds offer this often enough to justify their high fees.
What is downside protection? As far as I could tell this is more a colloquial term with no widely accepted technical definition. There are many ways to compare the NAV movement of a mutual fund (in this article this mean active funds only) and a relevant index.
- We could compare their absolute volatility using standard deviation. This is a measure of how monthly returns over a given duration fluctuate compared to the average monthly return. Higher the standard deviation, higher the fluctuation in the NAV. This takes into account both positive and negative movements.
- We could measure volatility in relative terms using beta. This tells you how much or less volatile a fund is with respect to the index. Or it tells you how the fund responds to a movement in the market. Beta > 1 = more volatile, Beta < 1 = less volatile, Beta =1 = just as volatile. This also takes into account both positive and negative movements.
- We could measure the ulcer index. This is a measure of how much and how long the NAV falls from a peak. It measures volatility only when the NAV falls. Lower the ulcer index, lower the downside fluctuation and lower the stress (which was incorrectly thought to cause Ulcers)
- We could measure downside capture. This measures how much of a benchmark’s monthly losses (if monthly return < 0) a fund captures. A downside of 80% means a fund has captured only 80% of the index losses.
There are many other ways to measure downside risk. We shall use the downside capture as a measure of downside protection in this study.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! 🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
How downside capture is computed: Study monthy returns over a given period (say 1 year or 3 years). Look at the fund returns for months when the index returns were negative. Compute CAGR of the fund and CAGR of the index only using these months.
Downside capture = CAGR of fund/CAGR of the index.
How we shall define downside protection: Let us take the example of a five-year window. We find out downside capture ratios (DCR) for every possible five year period from April 3rd 2006 to Mar 9th 2020 (when this study was done). Suppose we have 2000 such DCRs.
Downside protection consistency = (no of DCRs < 100%)/(total no of DCRs)
This tells you the fraction of instances when the fund captured less than index losses over a given period (five years in this example). You may agree or disagree with this definition of downside protection.
If you disagree, please provide an alternative definition and test it rigorously. Do not pick any random dates and claim active mutual funds provide or do not provide downside protection. That is lazy work but then again most readers are not discerning enough to appreciate rigorous from lazy. The trick is to set the bar well above that.
Do active mutual funds offer downside protection?
To answer this, we take 258 active mutual funds (regular plans for longer history) from these categories. The benchmarks used are also shown. As argued already, an aggressive hybrid fund is expected to fall lower than a broad market index, hence the use of Nifty 100. Nifty large and midcap 250 is a tougher benchmark than Nifty 200 or Nifty 500. Nifty Midcap 150 is a tougher benchmark than Nifty Smallcap 250. See: Why your small cap mutual fund must beat this benchmark!
Category | Benchmark |
Aggressive Hybrid Fund | Nifty 100 TRI |
Equity Linked Savings Scheme | Nifty 100 TRI |
Focused Fund | Nifty 100 TRI |
Large Cap Fund | Nifty 100 TRI |
Value Fund | Nifty 100 TRI |
Large & Mid Cap | Nifty Largemidcap 250 TRI |
Multi Cap Fund | Nifty Largemidcap 250 TRI |
Mid Cap Fund | NiftyMidcap150TRI |
Small cap Fund | NiftyMidcap150TRI |
We shall compute rolling downside capture over 3,5,7,10 and 13 years and the compute the downside protection consistency as defined above. We shall define a downside protection consistency of 70% as “good”. That is 7 out of 10 windows an active fund is expected to fall less than the index. This is subjective but reasonable in my opinion.
Results for 13 years
- min requirement 200 downside capture data points (this is necessary to ensure NAV history length of all the funds in the sample set is reasonably the same)
- No of funds: 94
- Funds with downside protection more than (or = to) 70% 78 (83%)
Results for 10 years
- min requirement: 800 downside capture data points
- No of funds: 97
- Funds with downside protection more than (or = to) 70% 71 (73%)
Results for 7 years
- min requirement: 1500 downside capture data points
- No of funds: 101
- Funds with downside protection more than (or = to) 70% 67(66%)
Results for 5 years
- min requirement: 1000 downside capture data points
- No of funds: 160
- Funds with downside protection more than (or = to) 70% 108 (68%)
Results for 3 years
- min requirement: 1000 downside capture data points
- No of funds: 173
- Funds with downside protection more than (or = to) 70% 103 (60%)
So it reasonable and fair to say, in the past, finding an active fund that tends to fall less than then the index was better than a coin toss (50%).
Now let us get to return outperformance. We shall define a,
return outperformance consistency = no of time fund beat index/tot no returns.
For example, say we have 100 13-year return data points and a fund got a return higher than the index in 65 of those instances. Then return outperformance consistency = 65/100 = 65%.
We shall exclude aggressive hybrid fund as they do not have a mandate to beat Nifty 100 (or NIfty) in terms of return.
Results for 13 years
Out of 80 funds, only 35 (44%) have a return outperformance consistency of >= 70%. Out of these, 34 funds have downside protection consistency >=70%
Results for 10 years
Out of 83 funds, only 37 (44%) have a return outperformance consistency of >= 70%. Out of these, 27 (73%) funds have downside protection consistency >=70%
Results for 7 years
Out of 87 funds, only 36 (41%) have a return outperformance consistency of >= 70%. Out of these, 22 (61%) funds have downside protection consistency >=70%
Results for 5 years
Out of 143 funds, only 62 (43 %) have a return outperformance consistency of >= 70%. Out of these, 47 (75%) funds have downside protection consistency >=70%
Results for 3 years
Out of 145 funds, only 34 (24%) have a return outperformance consistency of >= 70%*. Out of these, 24 (70%) funds have downside protection consistency >=70%
* Before we conclude anything about this low number, it would be better to wait for the market homogenize as mentioned here: Why this market crash could be healthy after all!
It is clear that the odds of active funds beating the index in terms of returns is just about a coin toss (50%). For most of the funds that have beat the index, downside protection is a key ingredient.
If we consider downside protection independently, it is more common than a coin toss to see an active fund fall less than the index. Active funds to tend to provide downside protection. This, however, does not always help it beat the index.
In conclusion, 60-70% of active funds do provide downside protection. However, only 60-70% of such active funds go on to get a better return than the market. As an analyst, this is reasonable performance by active funds. As an investor, we must recognise that the problem is to “stay invested in active funds that beat the market in terms of risk and return”.
This is essentially a coin toss (~ 50% probability). That is why one should shift to index funds – because it is hard if not impossible to be invested in the right active funds at all times. Not look at performance between random dates and jump to conclusions.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! You can watch podcast episodes on the OfSpin Media Friends YouTube Channel. 🔥Now Watch Let's Get Rich With Pattu தமிழில் (in Tamil)! 🔥
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available! Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.
Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)