There's more than one way for an investment to beat the stock market. During bull markets, when share prices rise, mutual funds and exchange-traded funds that invest in highly volatile, fast-growing stocks tend to shoot up faster than broad stock market benchmarks such as the S&P 500. But such funds tend to lose more when stocks eventually tumble.
For the investors who hold them, that can be a problem on two fronts.
One is emotional: Seeing big negative numbers in your brokerage account may prompt you to sell out of stocks, a move that can damage your long-term prospects. The other is mathematical, says Bob Bacarella, founder of investment firm Monetta Financial Services. "We know by the math, if you experience a 30% decline, it's going to take a 42% return to make that up," he says. "That's a lot of ground to make up. It's always advisable to try to avoid volatility and significant declines in your investments."
If you're buying a stock mutual fund or ETF, consider the other way to win: By losing less when stocks slide. Even if an investment's returns are ho-hum when stocks are skyrocketing, its ability to hold up better during downturns can produce market-beating returns over time.
From late 1989 through the end of 2019, a portfolio that performed 90% as well as the S&P 500 when stocks were rising but sank only 80% as much when stocks were falling would have handily beaten the S&P, according to data from Alliance Bernstein.
For potentially market-beating long-term returns without the pain of outsize drawdowns, keep an eye on these four metrics when investigating a potential investment. All of them take into account data from the past. And while past performance is no guarantee of future results, taken together, these measures can give you an idea of how an ETF or mutual fund typically behaves. All these data points are available for free on investing research sites such as Morningstar.com.
In investing lingo, letters of the Greek alphabet tend to indicate a tricky investing concept, but the idea behind beta is relatively straightforward. "Beta is a simple way of saying risk to the market," says Will Rhind, founder and CEO of ETF firm GraniteShares.
If a mutual fund or ETF has a beta of 1, that means it has historically tended to move in lockstep with a benchmark index. This is the case with the SPDR S&P 500 ETF Trust (symbol: SPY), an ETF designed to track the S&P 500. If a fund has a beta of less than 1 over a particular time period, it's taken on less risk than the market. The iShares MSCI USA Min Vol Factor ETF (USMV), an ETF designed to tamp down on volatility, for instance, has a beta of 0.73 over the past five years.
Video by Stephen Parkhurst
Another way to measure volatility over time is standard deviation, which, in general statistical terms, is a measure of how spread out data is from the mean. The higher a fund's standard deviation, the more its month-to-month returns have tended to deviate from its average monthly return.
To determine how volatile a fund's returns have been over time, compare its long-term standard deviation to that of a market index. Vanguard Dividend Appreciation (VIG), a dividend-focused ETF, has a 10-year standard deviation of 11.85 compared with a 13.23 standard deviation in the S&P 500 over that period.
Taking the percentage difference between the two, we can say that the Vanguard fund has been 10% less volatile than the broad stock market over the past decade. Both measures can be found on Morningstar by searching for a fund and clicking on the "Risk" tab.
"Looking at a volatility measure like beta can tell you if a manager is taking a lot of risk or not," says Brian Cayon, chief investment officer at Waukesha State Bank Wealth Management. "But it doesn't tell you how good a job they're doing at managing that risk."
That's where downside capture ratio, which can also be found on a fund's Morningstar "Risk" page, comes in.
Video by Stephen Parkhurst
The downside capture ratio shows how a fund performed over a given period of time, on average, when the benchmark index was declining. A fund with a ratio of 120 "captured" 120% of the benchmark's losses, meaning it lost 20% more than the index, on average, when it declined. Funds with ratios under 100 tend to hold up better than the index when stocks fall.
The Invesco S&P 500 Quality ETF (SPHQ), which focuses on blue-chip firms, such as Apple and Procter & Gamble, has a 10-year downside capture ratio of 83, meaning the over the past decade, for every dollar decline in the S&P 500, the fund lost 83 cents, on average.
Even if a fund looks favorable on volatility and downside measures, make sure it's been a good long-term performer overall by checking its track record. Focus on long-term results but don't rely solely on 10- or 15-year returns, because they can be skewed by recent results. Instead, look at year-to-year returns and favor funds with a record of beating their benchmarks and peer funds year in and year out.
For this exercise, focus particularly on how the fund has performed in times when the stock market has been extra volatile, says Bob Tull, co-founder and president of ETF provider ProcureAM. "Pull up the fund's performance from 2000 through 2003 and then again from 2006 to 2010," he says. "That should be an indicator of whether you have good downside protection built into this investment strategy."
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