The Asymmetry Ratio

 

   

One of the tools we use to evaluate funds at CWM is the Asymmetry Ratio (AR), created by F-Squared.  It stems from the idea that you want to own equity mutual funds that do well in the good times and lose less in the bad times.  In fact, downside protection is often more important than participating in the upside.  This is due to compounding magnifying the gains needed after a loss.  For example, if you lose 10% you need to make 11% to get back to your original investment; on the other hand, if you lose 30% you need to make 43% to get back to the original number.

 

How does the Asymmetry Ratio work?   For both up and down markets it compares the mutual fund returns with that of a benchmark.  In up (bull) markets it compares the gain against the benchmark; this is called the "Upside Capture Ratio (UCR)".   In down (bear) markets it compares the loss to the benchmark; this is the "Downside Capture Ratio (DCR)".  For example, say a fund went up 11% while the benchmark went up 10% over a market cycle: the fund's UCR would be 110%.  Now let's say that same fund lost 25% when the benchmark lost 20%: the fund's DCR is 125%.  The Asymmetry Ratio is just the difference between the two, or 110% - 125%, or -15%.

Why would we use the Asymmetry Ratio?  Funds with a high AR have historically outperformed the S&P 500.  Look at the following graph:

So if we can identify funds with an AR > 5% we stand a good chance of at least beating the benchmark.  Another means of observing the power of the Asymmetry Ratio in explaining performance is to show fund returns when sorted by Asymmetry Ratio. For this analysis, the Large Cap Blend peer group was ranked by Asymmetry Ratio, best to worst. The peer group was then broken into deciles, based on the Asymmetry Ratio. (Note: the Asymmetry Ratio of the best decile was 14.2%, and was -11.5% for the worst decile.)

The graph below shows the average annual return for the mutual funds in each decile. The funds in the top decile, as ranked by Asymmetry Ratio, had an average annual return of 1.6% for the period, while the funds in the bottom decile, as ranked by Asymmetry Ratio, had an average annual return of -3.8%.

Thus the bottom decile of funds lagged the top decile by 5.2% per annum for the most recent full market cycle (bull and bear markets).

 1 Time period 10/07 - 6/11; 2 Sources: Morningstar, F-Squared Investments

Is the Asymmetry Ratio predictive?  As it turns out, yes.  One exercise is to score funds by their AR at some point in time, and then see how those funds did over the next bull and bear markets.   The following graphs shows the results of picking funds with an AR > 5% and a DCR < 90%.

FMC stands for full market cycle.

Interestingly enough:
* 24% appeared in the 1st decile of their peer group in a future FMC (random distribution would equal 10%);
* 50% earned a top quartile ranking (random distribution would equal 25%);
* 73% were above median in a future FMC (random distribution would equal 50%).