When evaluating investment performance, most investors would agree that understanding the difference between absolute and relative returns is critical.
In this post, you'll learn the key distinctions between these two core return metrics, how they each provide value in analysis, and why both absolute and relative returns play vital roles in aligning portfolio outcomes with investor objectives.
You'll see definitions and examples of absolute and relative returns, gain insight into their respective formulas and benchmarks, and discover how synthesizing these return perspectives can empower more informed investment decision-making.
Introduction to Absolute and Relative Returns in Investment Performance
This section provides an overview of the key concepts of absolute return and relative return in the context of investment performance. It sets the foundation to analyze how these metrics allow investors to evaluate investments.
Understanding Absolute Return
Absolute return refers to the raw return of an investment without comparing it to any benchmark. It measures how much an investment's value has increased or decreased over a period of time in absolute terms.
For example, if a mutual fund returned +15% over the past year, that would be its absolute return regardless of how the overall stock market performed. Tracking absolute returns allows investors to gauge if their investment strategy is generating consistent positive returns.
Exploring Relative Return Meaning
Relative return compares the performance of an investment to a benchmark index over the same period. It shows how well or poorly an investment has done relative to the market or other investments.
For instance, if a hedge fund returned +10% last year while the S&P 500 returned +18%, the hedge fund underperformed the market with a relative return of -8%. Analyzing relative return helps investors determine if active investment strategies are worth higher fees or added risks compared to passive index funds.
Comparing Absolute and Relative Returns
While absolute return shows the total profit or loss of an investment, relative return accounts for external factors like market volatility and economic conditions. An investment can have positive absolute returns but still underperform its benchmark in a bull market in terms of relative return.
Alternatively, a hedge fund pursuing absolute returns might provide positive returns every year but still lag behind when compared to equity indexes over longer periods. Evaluating both absolute and relative returns provides fuller context on investment performance.
What is an example of a relative return?
A relative return measures how an investment has performed compared to a benchmark or market index over a specified period of time. Here is an example to illustrate the concept:
Let's say you have an investment portfolio (P1) that returned 30% over the past 3 years. Over that same 3 year period, the S&P 500 index (the benchmark) returned 15%.
To calculate the relative return:
Relative Return = (Return of P1 - Return of Benchmark) / Return of Benchmark
Plugging in the numbers:
Relative Return = (30% - 15%) / 15% = 15% / 15% = 100%
So P1 has a relative return of 100% compared to the S&P 500 over that 3 year period. This means it outperformed the benchmark by 100%.
Thus, the relative return shows that P1 performed significantly better than the broader market, as represented by the S&P 500. An investor would be happy to see a high relative return, as it indicates their investment strategy is working well compared to a standard benchmark.
The key thing to remember about relative return is that it measures an investment's performance relative to a benchmark. It differs from absolute return, which just looks at the raw return without comparing it to anything else. Relative return provides more context and indicates if a strategy is adding value compared to just investing in the overall market.
What is the difference between absolute return and actual return?
The key difference between absolute return and relative return lies in how each measures investment performance.
Absolute return measures the actual return, in percentage or dollar terms, that an investment gains or loses over a specific time period. It does not compare the return to any benchmark. For example, if a mutual fund returned +5% last year, its absolute return was 5%.
Relative return measures how an investment performed compared to a benchmark, like the S&P 500 index. For example, if a mutual fund returned +5% last year but the S&P 500 returned +8% over the same period, the fund underperformed its benchmark. Its relative return would be -3%.
In summary:
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Absolute return measures the raw return of an investment over a period of time. It does not compare returns to a benchmark.
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Relative return compares an investment's return to a benchmark return over the same period. It shows if the investment outperformed or underperformed the benchmark.
Investors use both absolute and relative return metrics to evaluate investments. Absolute return shows the raw profit or loss. Relative return accounts for market conditions and helps compare performance across investments. Used together, they provide a more complete picture of how well an investment has done.
What is the difference between absolute return and total return?
Absolute return refers to the total return of an investment, independent of any benchmark or market index. It measures the raw gain or loss of an investment over a period of time.
In contrast, relative return compares the performance of an investment to a benchmark index, like the S&P 500. It shows how much an investment outperformed or underperformed the market.
Some key differences between absolute and relative return:
- Benchmark - Absolute return has no benchmark. Relative return compares to a benchmark like an index.
- Performance Context - Absolute return lacks context about how it stacks up to the market. Relative return shows if performance beat the market.
- Investment Types - Absolute return is common with hedge funds, which have broad mandates. Relative return tends to be used more with long-only funds like mutual funds.
- Fees & Expenses - Absolute return figures tend to be reported after fees and expenses have been deducted.
In summary, absolute return shows the raw performance of an investment while relative return factors in the market's performance. Investors should look at both metrics to fully evaluate an investment opportunity.
What is an example of an absolute return?
An absolute return refers to the actual return, in percentage or dollar terms, that an investment achieves over a given period of time. For example, if you invested $10,000 in a mutual fund and it grew to be worth $15,000 over 5 years, your absolute return would be 50% ($15,000/$10,000 - 1 = 0.5 = 50%).
Some examples of absolute returns:
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A stock purchased for $50 per share increases to $75 per share over 3 years. The absolute return is 50% ($75/$50 - 1 = 0.5 = 50%).
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A real estate property was purchased for $300,000 and sold for $450,000 three years later. The absolute return is 50% ($450,000/$300,000 - 1 = 0.5 = 50%).
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An investor contributed $20,000 to a retirement account. After 10 years, the account balance grew to $36,000. The absolute return is 80% ($36,000/$20,000 - 1 = 0.8 = 80%).
The key thing is that absolute return looks at the actual growth of an investment over time. It does not compare the returns to any benchmark or measure how the investment performed relative to the broader market. An absolute return simply states, in concrete terms, how much the investment went up or down.
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Distinguishing Absolute Return from Relative Return
Absolute return and relative return are two important investment performance metrics that differ in their approaches.
Absolute Return vs Relative Return: Core Principles
Absolute return measures the raw return of an investment, without comparison to any benchmark. It simply calculates the percentage gain or loss of the investment over a period. For example, if a stock is purchased at $50 per share and sold a year later at $60 per share, the absolute return is 20% [($60-$50)/$50].
Relative return compares the performance of an investment to a benchmark index like the S&P 500. It measures how much an investment outperformed or underperformed the benchmark. For example, if a mutual fund returned 10% in a year when the S&P 500 returned 8%, its relative return would be +2%.
Impact of Market Volatility on Returns
In volatile market conditions, relative return helps contextualize investment performance. If the S&P 500 drops 10% during a market crash but a hedge fund only drops 5%, it actually performed well on a relative basis despite negative absolute returns.
However, absolute returns matter more for strategies promising positive returns regardless of market conditions, like absolute return funds. If a fund aims for 10% absolute returns but loses money due to volatility, investors pay the price.
The Role of Benchmarks in Relative Returns
Benchmarks allow investors to assess if portfolio managers are adding value. Beating the S&P 500 means a manager's stock picking skills or strategy outweighed broader market forces. Underperformance means market factors dominated returns more than the manager's decisions.
Different asset classes have different benchmarks. Comparing a bond fund's returns to the S&P 500, for example, makes little sense. Appropriate benchmarks must be used to properly contextualize relative performance.
Absolute Return vs Relative Return Example
Here is an example comparing the two metrics:
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S&P 500 return: +15%
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Hedge Fund A return: +25%
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Hedge Fund B return: -5%
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Hedge Fund A had strong absolute returns of +25%, but its relative return versus the S&P 500 was +10% (25% - 15%).
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Hedge Fund B had negative absolute returns of -5%, underperforming the market. Its relative return was -20% (S&P 500 was 15% higher).
In this case, Hedge Fund A outperformed the market while Hedge Fund B lost money against the benchmark. But Fund B's manager could argue the market neutral strategy preserved capital during a volatile period for conservative investors. The choice depends on one's goals - absolute returns or relative outperformance.
Absolute Return Strategies and Instruments
Absolute return strategies aim to achieve positive returns regardless of market conditions by utilizing various investment instruments and techniques.
Utilizing Derivatives for Absolute Returns
Derivatives like futures, options and swaps allow investors to hedge risks or speculate on price movements across different asset classes. By using derivatives, absolute return funds can generate gains in both rising and falling markets. For example, short selling stock index futures during a market downturn can produce positive returns.
The Function of Short Selling in Absolute Returns
Short selling involves borrowing then selling securities in hopes of repurchasing them later at a lower price for a profit. This technique can generate absolute returns in declining markets. Absolute return managers may short sell overvalued stocks or indexes if they forecast prices will fall.
Arbitrage Techniques in Absolute Return Strategy
Arbitrage seeks to exploit brief price discrepancies between equivalent assets to lock in small, low-risk profits. It is a key tactic used by absolute return hedge funds. For instance, a fund might simultaneously purchase an asset in one market while short selling it in another market if there is a price difference between the two.
Investment Products Geared Towards Absolute Returns
Hedge funds and private equity firms often target absolute returns over relative returns. They utilize extensive risk management, unconventional assets, leverage, derivatives, short selling and arbitrage to try generating positive returns in all market environments. The flexibility of their investment mandates allow them to swiftly capitalize on various strategies for an absolute return.
Calculating Absolute and Relative Returns
Absolute Return Formula and Calculation
The absolute return of an investment is the total return, expressed as a percentage, over a set period of time. The formula is:
Absolute Return = (Current Value - Original Value) / Original Value
For example, if you invested $10,000 and the investment is now worth $11,000, the absolute return would be:
(11,000 - 10,000) / 10,000 = 0.1 = 10%
So your absolute return is 10% over that time period.
To calculate annualized absolute returns, divide the total return by the number of years:
Annualized Absolute Return = Total Absolute Return / Number of Years
So if you earned that 10% over 5 years, your annualized return would be 2% per year.
Using an Absolute Return Calculator
Using an absolute return calculator can simplify the process of determining investment performance. Most will allow you to input the original investment amount, the current value, and the timeframe to automatically calculate your total and annualized returns.
Online calculators provide an easy way to determine absolute returns without having to manually apply formulas. Just input your figures and it will provide the mathematical calculations for you.
Measuring Relative Return Against a Benchmark
Relative return measures how well an investment performed in comparison to a benchmark index, like the S&P 500. It tells you if the investment beat the benchmark or not.
The formula is:
Relative Return = Investment Return - Benchmark Return
For example, if your investment returned 6% over the past year and the S&P 500 returned 4% over that same timeframe, your relative return would be:
6% - 4% = 2%
So your investment outperformed the benchmark by 2%. If the investment return was lower than the benchmark, the relative return would be negative.
Understanding Trailing and Rolling Returns
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Trailing returns look at the performance of an investment over a historical period up to the present time. For example, 5-year trailing returns calculate the annualized performance over the immediately preceding 5 year timeframe.
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Rolling returns measure performance over a consistent time interval that moves forward over time. For instance, 36-month rolling returns always look at the preceding 36 months as the timeframe shifts ahead.
These can both be used to evaluate relative returns compared to a benchmark on a dynamic basis over different historical periods.
Investment Vehicles and Their Return Profiles
Hedge Funds and Absolute Return Reporting
Hedge funds are often structured as limited partnerships or limited liability companies. This allows them greater flexibility to utilize investment strategies like short selling, trading futures and options contracts, and other more complex derivatives and arbitrage techniques.
Given their specialized investment approach, hedge funds typically report performance using absolute returns rather than comparing to a benchmark. This gives investors a clearer picture of the fund's actual profit and loss rather than how it stacks up against market indexes.
Some key things to know about hedge funds and absolute returns:
- Absolute returns show the fund's real performance numbers rather than masking volatility
- Help assess if investment strategies are working regardless of wider market conditions
- The flexibility of the fund structure allows more leeway to target absolute returns
- Investors can better understand the risk-return profile over time
Mutual Funds and the Importance of Relative Return
Unlike hedge funds, mutual funds are structured as regulated investment companies and market themselves based on relative return against peers. The relative return shows how a mutual fund performs against its category benchmark and other funds with similar investment objectives.
Some key things to know about mutual funds and relative return:
- Allow investors to evaluate performance against comparable fund categories and indexes
- Useful metric to determine if active fund management is adding value
- Positions the fund against competitors when selecting investments
- Still important to consider absolute returns to gauge volatility and risk
Fixed-Income Securities and Return Metrics
Fixed-income securities like government and corporate bonds are uniquely positioned where both absolute and relative returns are important metrics for investors.
On an absolute basis, fixed-income is measured by yield which indicates the actual dollar amount earned on the original investment. This allows assessing the asset's fundamental profitability.
However, relative return is still a crucial metric as it shows how bond yields compare to prevailing interest rates and alternative fixed-income options. This helps investors determine if they are being adequately compensated for inflation and other risk factors.
The Significance of Security’s Alpha
A stock's alpha is a measure of performance on a risk-adjusted basis compared to the broader market, usually the S&P 500. A positive alpha indicates that an investment has gained more than would be expected given its beta or volatility.
Some key things to know about alpha:
- Helps determine if active management has added value for shareholders
- Indicates if a security has beaten the market after controlling for risk
- Compares actual returns to those of a benchmark index fund
- Can demonstrate skill and expertise of investment managers over time
So while absolute return is an important metric, alpha specifically shows if investment selections have exceeded market returns for comparable risk profiles. For long equities, this relative performance measure carries significant weight for investors.
Choosing Between Absolute and Relative Returns
Alignment with Investor Objectives
When deciding between analyzing absolute or relative returns, investors should consider how each approach aligns with their financial goals and objectives.
Absolute returns focus solely on the performance of an investment itself, without comparing it to any benchmark. This helps determine if an investment is generating satisfactory positive returns on its own. Absolute returns suit investors seeking stable capital appreciation regardless of broader market conditions.
Conversely, relative returns measure how well an investment performs compared to a benchmark like the S&P 500 index. This approach helps ascertain if active investment strategies are worthwhile. Relative returns better fit investors aiming to beat the market.
Ultimately, aligning return analysis with core investment aims provides the most meaningful performance assessment.
The Role of a Financial Advisor in Return Analysis
Consulting a financial advisor can provide key insights when evaluating absolute and relative returns. Advisors consider factors like an investor's risk tolerance, time horizon, portfolio construction, and return expectations when recommending appropriate benchmarks.
For example, less risk-averse investors with longer time horizons may use broader market indexes as performance yardsticks. More conservative investors may compare returns to lower-risk fixed income securities.
Financial advisors can also contextualize returns appropriately based on prevailing economic conditions. This prevents investors from making knee-jerk reactions to temporary market volatility.
Having an experienced guide assess returns and benchmarks leads to better-informed investment decisions.
Adapting to Market Conditions and Investor Risk Profiles
In turbulent market environments, analyzing absolute returns helps determine if an investment's fundamentals remain strong regardless of wider trends. During such times, relative performance comparisons become less relevant.
However, when markets are steadily rising, benchmarking to indexes can ascertain if a portfolio is keeping pace with broader growth rates. Outperformance can signal savvy active management.
Likewise, conservative investors may prefer absolute returns to evaluate stability, while aggressive investors benchmark to indexes when seeking market-beating gains.
Adjusting return analysis based on ever-shifting investor risk appetites and macroeconomic cycles is key.
Portfolio Construction and Return Expectations
Portfolio construction relies heavily on return expectations. Investors targeting fixed absolute returns tailor assets to meet specific income thresholds. However, investors aiming for market-relative outperformance focus more on securities with benchmark-beating potential.
Concentrating solely on absolute or relative returns when building a portfolio can be risky. Blending assets geared toward both absolute stability and active gains helps mitigate volatility. This diversification allows portfolios to remain robust across diverse economic environments.
Just as return analysis should align with investor goals, portfolio construction must account for both absolute and relative return targets to enable stability.
Conclusion: Synthesizing Absolute and Relative Return Insights
Recap of Absolute vs Relative Return
Absolute return measures the total return of an investment, without comparison to any benchmark. It simply shows how much the investment has gained or lost over a period.
Relative return compares the return of an investment to a benchmark index, like the S&P 500. It shows how the investment performed in relation to the broader market.
Both metrics provide useful insights. Absolute return shows the raw profitability of an investment. Relative return gives context on performance by comparing to a benchmark.
Final Thoughts on Return Metrics
When evaluating investments, both absolute and relative return offer value:
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Absolute return demonstrates the total profit or loss from an investment. This helps assess overall performance.
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Relative return provides perspective by benchmarking against indices. This normalization allows for comparison between investments.
Understanding both absolute and relative returns leads to better-informed decisions when constructing portfolios aligned to an investor's goals and risk tolerance. Used together, the metrics build a more complete picture.
