The Art of Losing Less in a Bear Market

The bond market is a little nervous. Although inflation has come down and unemployment is low, there are worries that inflation will bounce back, and the Federal Reserve will hit the brakes on its interest-rate cut plans. That makes stocks unhappy.

The market always has worries, so it makes sense to stay pretty fully invested, but a little effort on downside protection can help you get through the next selloff, whether it happens next month or three years from now.

So, I sought out funds with the greatest downside-capture ratios. That’s a measure Morningstar uses to calculate how much of a market selloff a fund “captures.” A figure over 100% means that the fund lost more than the broad benchmark in past selloffs, and a figure below that means it lost less. A negative figure means it actually made money. The broad benchmarks used to calculate the figures were the S&P 500, Bloomberg US Aggregate Bond, MSCI ACWI, and MSCI ACWI ex USA.

I used 10-year downside-capture ratios to be sure there would be a fair amount of data.

Now for the caveat: A low downside-capture ratio does not equate to no or even low risk. It tells you that a fund has been a good diversifier from the broad market.

That’s why I also measured the max drawdown over the trailing 10 years. That tells you in absolute terms what a fund’s loss potential has been by measuring its largest peak-to-trough loss. Generally, these two measures tell a similar story but not always. For example, if a fund is flat in all down periods but loses 20% in rallies, it will have a downside capture of 0 and a drawdown of 20%. If it gains 10% in down periods and loses 20% in rallies, it will have a negative downside capture and a drawdown of roughly 30%. Some funds are great diversifiers but still have their vulnerabilities. To get true zero downside, you’d need a certificate of deposit or maybe an ultrashort bond fund. But then your risk is that inflation outstrips your return.

First, I will highlight five funds that had low or negative downside-capture ratios. Then I will highlight strategies with Morningstar Medalist Ratings of Gold, Silver, or Bronze that had the lowest downside captures among the funds in the Morningstar FundInvestor 500 in their respective equity categories. These are funds that tend to run on the lower-risk side of their peer group and therefore can help you to manage the downside but will still lose money in most bear markets.

Super Diversifiers

OK, let’s look at the really low downside-capture funds. Four have negative downside-capture figures, and one has a very low but positive downside-capture ratio. These make nifty diversifiers but are unlikely to produce long-term returns comparable to equity funds.

The fund with the lowest downside capture is Virtus AlphaSimplex Managed Futures Strategy AMFAX. This Bronze-rated alternatives fund uses very complicated strategies that feature commodities, shorts, futures, and rather high fees. It employs a variety of trend-chasing models to invest in over 100 markets ranging from US equities to iron ore and carbon emissions.

In 2020, the fund gained 12%, and in 2022 it gained an awesome 35%. But in 2023, it lost nearly 11%. Thus, you get a downside-capture ratio of negative 18% but also a max drawdown of 23%. So, it has provided nifty diversification, but it isn’t an all-weather vehicle. In fact, we consider the systematic trend Morningstar Category as being “opportunistic.” These alternative strategies generally focus on absolute return. They can deliver big returns and suffer significant losses—though not always aligned with the broader market.

Pimco Short-Term PSHAX is a much more reliable albeit low-return vehicle. The Bronze-rated fund boasts a downside-capture ratio of negative 17.7% and a max loss of 3.0%. When interest rates backed up in 2021-22, it lost a little money, but typically it produces a modest return of between 2% and 4%. Short-term bonds are good spots to build money for upcoming expenditures and emergency funds.

Bronze-rated Fidelity Floating Rate High Income FFRHX is a solid diversifier for a bond-heavy portfolio. It owns corporate loans that reset at higher rates when interest rates rise and at lower rates when rates decline. Generally, it moves in the opposite direction of a long-term bond fund. It has a decent yield and helps reduce a portfolio’s interest-rate risk. It boasts a downside capture of negative 16.7% and a max loss of 13.0%.

T. Rowe Price Floating Rate PRFRX is a similar story. It, too, is a Bronze-rated bank-loan fund. Its downside-capture ratio is a little lower, but so is its max drawdown.

On the other hand, we consider the Bronze-rated Merger Fund MERFX to be a “diversifier” in alternatives land. Diversifier alternatives focus on tapping into nontraditional or alternative risk factors to offer a more diversified source of long-term returns. The Merger Fund is a tamer form of alternatives investing. Event-driven strategies tend to deliver more modest—but more consistent—returns compared with systematic trend-following strategies, such as the Virtus AlphaSimplex fund. The fund buys merger-acquisition targets and shorts the buyer. If the deal goes through, the fund makes money. If it doesn’t, it loses. The cool part is that it has a low correlation with the stock market, so it’s a nice diversifier. It’s a pretty low-key fund whose returns tend to be in the single digits. Its downside capture and max drawdown are just 1% and 4%, respectively.

Lower-Risk Equity Strategies

I was pleased to see that many of the funds I consider to be lower-risk investments showed up in my screen for category-leading downside capture. If you have some volatile, aggressive funds, these can provide a bit of balance.

Vanguard Global Minimum Volatility VMNVX clocks in as our lowest downside-capture equity fund by design. The Silver-rated fund is passive, but it screens for less volatile stocks and hedges currency exposure to further temper big swings. It’s an appealing fund for retirement portfolios because you want to maintain exposure to foreign markets, but the added volatility can be a nuisance. This is just a classic low-cost, boring Vanguard fund.

First Eagle Overseas SGOVX has long been a standout in capital preservation. The Bronze-rated fund buys defensive equities and holds gold bullion and sometimes a sizable cash position in an effort to reduce losses. Matt McLennan and Kimball Brooker have worked together on the fund since 2010, and they’ve built a solid record of fairly steady returns. In 2022, the category benchmark lost 16.0%, but this fund lost just 8.1%. For the trailing 10 years, the fund was a hair behind the benchmark but with less risk, so that’s a fair trade.

Invesco Dividend Income IAUTX has played defense better than other large-value funds. Peter Santoro came on board in 2021 and implemented a more defensive approach that emphasizes cash flows and balance sheets rather than maximizing yields. We rate the fund at Bronze and the People and Process Pillars at Above Average as Santoro has impressed so far. In 2022, the fund gained 0.6% while the Russell 1000 Value lost 8.6%. The fund’s max drawdown over the past decade was 20.1%, and its downside capture was 69%.

Tweedy, Browne International Value TBGVX is a Bronze-rated bottom-up value fund that is very fundamentally driven. It has a downside capture of 70% and a max loss of 21.4%. We like this seasoned team and its indifference to hot investing trends. The team hedges currency exposure and will hold cash stakes, two things that consistently reduce volatility.

Vanguard Dividend Growth VDIGX is one of my favorite funds for its emphasis on quality companies with the potential to raise dividends. Unfortunately, quality has been really out of favor as artificial intelligence is dominating market performance. But quality is great for playing defense in recessions as companies with robust balance sheets and strong brands are bulwarks. The Gold-rated fund’s downside-capture ratio is 81%, and its max drawdown is 17.5%.

Royce Small-Cap Special Equity RYSEX is focused on clean accounting and low valuations. It’s been a longtime holding of mine as Charlie Dreifus and company are not just good at defense, but their brand of investing doesn’t track the broad market closely. The Bronze fund’s downside-capture ratio is 85%, and its max drawdown is 26%. (I own this fund in my 401(k).)

Large-growth funds tend to have high downside capture because of the volatile nature of technology and healthcare stocks, but Bronze-rated Calvert Equity CSIEX has moderated that volatility somewhat. The fund clocks in with 88% downside capture and a max drawdown of 25%. Subadvisor Atlanta Capital does three things that take risk down a notch: It follows an environmental, social, and governance strategy, it leans toward quality, and it pays more attention to valuations than its peers.

This article first appeared in the February 2025 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.