Absolute Return vs. Relative Return: An Overview
Knowing whether a fund manager 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.
Absolute return is simply whatever an asset or portfolio returned over a certain period. 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 also called alpha.
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.
- Absolute return is what an asset or fund returned over a certain period of time.
- Relative return is the return an asset or fund achieved over a period of time compared to a benchmark.
- Absolute return fund managers are focused on shorter-term results, whereas relative return fund managers are geared toward the bigger picture.
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.
An absolute return fund is positioned to earn positive returns by employing techniques that are different from a traditional mutual fund. Absolute return fund managers use short selling, futures, options, derivatives, arbitrage, leverage, and unconventional assets. The returns are looked at on their own terms, separate from other performance measures, with only profits or losses considered.
Absolute return managers have a 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.
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. Specifically, the relative return is a way to gauge a fund manager's performance. For example, an investor can always buy an index fund that has a low management expense ratio (MER) and will guarantee the market return.
If an investor is 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 it 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 a 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.
Absolute Return vs. Relative Return Example
One way to look at absolute return versus relative return is in the context of a market cycle, such as bull versus bear. In a bull market, 2% would be seen as a horrible return. But in a bear market, when many investors could be down as much as 20%, just preserving capital would be considered a triumph. In that case, a 2% return doesn't look so bad. The value of the return changes based on the context.
In this scenario, the 2% would be the absolute return. Relative return is the reason why a 2% return is bad in a bull market and good in a bear market. What matters in this context is not the amount of the return itself, but rather what the return is relative to.