Knowing whether a fund manager or broker is doing a good job can be a challenge for some investors. It's difficult to define what good is because it depends on how the rest of the market has been performing. For example, in a bull market, 2 percent is a horrible return. But in a bear market, when most investors are down 20 percent, just preserving your capital would be considered a triumph. In that case, 2 percent doesn't look so bad.

Conversely, absolute return managers have a very short time horizon. Most of these managers will not rely on long-lasting market trends. Rather they’ll look to trade the short-term price swings, both from the long as well as the short side.

Absolute Return

Absolute return is simply whatever an asset or portfolio returned over a certain period. In the paragraph above, the 2 percent we mentioned would be the absolute return. If a mutual fund returned 8 percent last year, then that 8 percent would be its absolute return. Pretty simple stuff.

Fund managers who measure their performance in terms of an absolute return usually aim to develop a portfolio that is diversified across asset classes, geography and economic cycles. Such managers pay special attention to the correlation between the different components of their portfolio. The goal is to not be subject to wild swings that happen because of a market event.

Absolute return does not say much on its own. You need to look at the relative return to see how an investment's return compares to other similar investments. Once you have a comparable benchmark in which to measure your investment's return, you can then make a decision of whether your investment is doing well or poorly and act accordingly.

Relative Return

Relative return, on the other hand, is the difference between the absolute return and the performance of the market (or other similar investments), which is gauged by a benchmark, or index, such as the S&P 500. Relative return is the reason why a 2 percent return is bad in a bull market and good in a bear market. (If you aren't familiar with indexes, read more on them in our Index Investing tutorial.)

Relative return is important because it is a way to measure the performance of actively managed funds, which should earn a return greater than the market. If not, you can always buy an index fund that has a low management expense ratio (MER) and will guarantee the market return. If you're paying a manager to perform better than the market but they're not producing a positive return over a long period of time, it may be worth your time to consider a new fund manager.

Many fund managers who measure their performance by relative returns typically lean on proven market trends to achieve their returns. They’ll perform global and detailed economic analysis on specific companies to determine the direction of a particular stock or commodity for a timeline that typically stretches out for a year or longer. (For further reading on returns, check out our article The Truth Behind Mutual Fund Returns.)