Here’s an interesting chart from the guys at LPL Financial. It encompasses stocks, bonds, commodities, but not forex. Considering gold and oil are FXL mainstays, along with treasuries, of course, I thought it might be beneficial to toss up here. Upside/downside capture is a financially convoluted way to measure which way your investment leans, up or down.
Upside/downside capture is a simple measure that shows how an investment relates to the movements of the stock market. Returns are separated into two groups: those when the stock market rises and those when the stock market falls. The capture shows the proportion between the asset’s returns and the overall stock market’s return. For example, if the average up return for the S&P 500® was 10% and the average up return for a particular asset was 7.5%, then the upside capture ratio would be 75% (7.5/10). Similarly if the average down return for the S&P 500® was -10% and the average down return for the asset was 12%, then the downside capture ratio would be 120% (-12/-10). The goal is to find assets that have a high upside capture, but a low or negative downside capture.
Chart 1 shows a scatter of upside/downside capture ratios for a broad set of asset classes based on returns during the past ten years. The quadrants depict the four possible combinations, i.e., lower upside/lower downside, lower upside/higher downside, higher upside/higher downside, and higher upside/lower downside. The 45-degree line shows equal upside/downside ratios.
There are several points that investors should consider when reviewing this chart:
Very few asset classes have exhibited true downside protection. Note that most asset classes fall close to the 45-degree line, which suggests that most asset classes participated equally in bull and bear markets.
Only one asset class, long-term treasuries had negative correlation to stocks, i.e., negative upside and downside capture ratios. Treasuries, and other fixed-income categories like high grade corporates and higher quality municipal bonds, should probably be the heart of any current strategy designed to truly protect against downside equity risk.
Although we don’t find gold attractive within the current market environment, gold was a reasonable diversifier over the past ten years. However, it hasn’t offered as much downside protection as it did upside participation. By contrast, commodities do not seem to offer an attractive upside/downside.
Hedge funds are not a panacea. Note that hedge funds have historically offered about 70% of both the upside AND the downside. There seem to have been many asset classes that offered similar captures with considerably lower fee structures. For example, an indexed combination of riskier fixed-income (emerging market sovereign debt and high yield corporates) had a superior upside/downside capture ratio to hedge funds.
Cash is generally a worthwhile diversifier. It exhibited minimal upside, but slightly negative downside.
Haphazard portfolio construction can be just as destructive as a poor investment decision. If you’ve been trading forex for awhile and nothing else use the wealth of insight and experience FXL has to offer for a few of the other asset classes – especially gold and oil.
