Relative Return

What Is Relative Return?

Relative return is the return an asset achieves over a period of time compared to a benchmark. The relative return is the difference between the asset’s return and the return of the benchmark. Relative return can also be known as alpha in the context of active portfolio management.

This can be contrasted with an absolute return, which is a standalone figure that is not compared to anything else.

How Relative Return Works

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.

Relative return is most often used when reviewing the performance of a mutual fund manager. Investors can use the relative return to understand how their investments are performing relative to various market benchmarks.

Similar to alpha, relative return is the difference between investment return and the return of a benchmark. There are some factors an investor must consider when using relative return. 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.

Relative Return Considerations

Transaction costs and standard versus total return calculations can affect relative return observations. Transaction fees can be a significant factor for investors dealing with high-cost intermediaries. Transaction fees often detract from a fund’s performance. Using standard versus total return can also be a factor since standard return may not include distributions and total return does.

Transaction Costs

Transaction costs can significantly impact a fund’s relative return. For example, the Invesco Global Opportunities Fund is a top-performing actively managed fund. As of Sept. 30, 2017, its one-year return significantly outperformed the MSCI All Country World Index. The Fund provides performance returns with and without sales charges which exemplify the effects transaction costs can have on relative return. For the one year through Sept. 30, 2017, the Fund’s Class A shares had a return of 30.48% without sales charges.

With sales charges, the one-year return was 22.97%. With and without sales charges the Fund outperformed the benchmark’s one-year return of 18.65%. To mitigate transaction costs and increase relative return an investor could potentially buy shares of the Fund through a discount brokerage platform.

Total Return

To help increase the relative return comparison, an investor can also use total return which considers distributions from the fund in its return calculations. Some standard return calculations do not include distributions and can therefore decrease the relative return.

Fund Fees

Fund fees are another factor that can influence relative return. Fund fees are unavoidable and must be paid collectively by fund shareholders annually. Investment companies account for these fees as liabilities in their net asset value calculations. Therefore, they impact the fund’s net asset value (NAV) for which return is calculated.

Passive mutual funds exemplify this in their returns. Investors can expect the relative return of a passive mutual fund to be slightly lower than the benchmark return due to operational expenses.

Absolute Return vs. Relative Return

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.

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 on whether your investment is doing well or poorly and act accordingly.

Relative Return Example

One way to look at absolute return vs. relative return is in the context of a market cycle, such as bull vs. 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 your 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% we mentioned would be the absolute return. If a mutual fund returned 8% last year, then that 8% would be its absolute return. Pretty simple stuff.

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 a benchmark or the broader market.