What is mutual fund downside protection and why is it important?

Would you prefer a fund that beats the index whenever the index moves up or would you prefer a fund that falls lower than the index? Our first response would be, why not both? Unfortunately, it is not as simple as that. Very few funds manage to do both. In this post, I discuss why downside protection is important in choosing a mutual fund.

In this post, I would prefer to steer clear of exact definitions. Those interested can consult: Nov 2017 Freefincal Equity Mutual Fund Outperformance Screener

What is upside performance consistency?

It is a measure of how often the fund beats the benchmark/index, when the index (market) moves “up”

What is downside protection consistency?

It is a measure of how often the fund protects (falls less) the investor when the market moves “down”

What is return outperformance consistency?

How often the fund has beaten the benchmark (see the video for an example).

Why can I have the best of both worlds?

Let us plot the return outperformance of 228 equity mutual funds vs their upside performance consistency. This is a schematic of the four sections. I discuss 7-year returns, but the trends are similar over 5Y and 3Y as well. You can check that with the screener file linked above.mutual fund downside capture map

Now for the data:

mutual fund downside protection vs rolling return outperformance

Notice that most funds that beat the benchmark do not seem to do well when the market moves up! This is counterintuitive and this is why downside protection is important as explained below.

What is mutual fund downside protection?

It is better to choose funds that beat the benchmark by protecting gains during market falls. This keeps the investor calm.

Even if the fund has failed to beat the benchmark, a good downside protection is valuable. More on this on a post about index investing.

The essential point is that the journey matters and not just the end points (returns).

This is a 3D summary of the video. Thanks to Anish for the suggestion.

3D graph of rolling returns vs downside capture vs upside performance

Mutual fund downside protection slide deck

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4 thoughts on “What is mutual fund downside protection and why is it important?

  1. Hi,
    I am a beginner in MF. I have been advised to start SIP in these funds. Based on the past performance, they don’t look so good. Can you inform if these will be good for a moderate risk investor?

    Asset Class Fund
    Large Cap IDBI India Top 100 Equity Fund – Growth
    Mid Cap Motilal Oswal M0st focused MidCap 30 Fund – Growth
    Index IDBI Nifty Index Fund – Growth
    MidTerm Corp Bond DHFL Pramerica Medium Term Income Fund
    GILT IDFC GSF – Provident Fund – Growth
    Commodities Birla Sun Life Gold Fund – Growth
    ShortTerm Corp Bond Principal Short Term Income Fund – Growth

  2. Hi Pattu sir, nice article. I have one observation. Dont you feel that it would also depend on risk appetite? e.g. if I am high risk investor, I would look to get higher returns when indexing is going up and I am okay even for downside. A moderate investor would also think of getting moderate returns compared to index returns and vice versa. Need your expert views on this

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