Absolute Return vs. Relative Return

Written By

Dan Buckley

Updated

Jun 16, 2023

Measuring performance is essential for assessing the effectiveness of a strategy and guiding future decisions. Two common methods used for this purpose are absolute return and relative return.

Each approach provides distinct information about an investment or portfolio’s performance.

Below we look into the differences between absolute return and relative return, discussing their respective definitions, key distinctions, and advantages and disadvantages.

Additionally, we will examine the factors affecting the performance of these investments, the role of asset allocation, and how to incorporate these strategies in a diversified portfolio.

Key Takeaways – Absolute Return vs. Relative Return

Measuring performance is important for evaluating the effectiveness of a strategy and making informed decisions. Absolute return and relative return are two common methods used for this purpose.

Absolute return focuses on the actual gains or losses generated by an investment, independent of market conditions or benchmarks.

Relative return compares an investment’s performance to a benchmark, indicating its ability to outperform or underperform the market.

Absolute return strategies aim for consistent positive returns in any market condition, while relative return strategies prioritize outperforming a benchmark.

Both approaches have their advantages and disadvantages, and a balanced portfolio may incorporate elements of both strategies for optimal results.

Definition and Overview of Absolute Return and Relative Return

Absolute return is the actual gain or loss generated by an investment or portfolio over a specific period, expressed as a percentage.

It is an independent measure of performance that does not rely on comparisons to benchmarks or other investments.

On the other hand, relative return is the difference in performance between an investment or portfolio and a benchmark index, usually represented as a percentage.

This method of evaluation enables investors to compare their trading performance or investments against market performance, providing a context for understanding how well an investment strategy is performing.

Understanding the Key Differences between Absolute Return and Relative Return

Absolute return focuses on the actual profits or losses generated by an investment or portfolio, without any reference to the broader market or other investments.

This method is useful for evaluating the performance of investments that aim to achieve consistent positive returns, regardless of market conditions.

Conversely, relative return compares an investment’s performance to that of a benchmark index, highlighting the investment’s ability to outperform the market.

Relative return is often used to assess the performance of actively managed funds like mutual funds, as it reveals whether the fund manager’s decisions have generated added value compared to a passive index fund.

Measuring Performance with Absolute Return and Relative Return Metrics

Absolute return is usually calculated as the percentage change in the investment’s value over a specified time period.

This measure can be positive or negative and is often expressed as an annualized return to facilitate comparisons across different time horizons.

Relative return, in contrast, is calculated by subtracting the benchmark index’s return from the investment’s return over the same time period.

A positive relative return indicates that the investment has outperformed the benchmark, while a negative relative return signifies underperformance.

Absolute Return vs. Relative Return Strategies – Pros and Cons

Absolute return strategies typically focus on achieving positive returns in any market condition, often employing advanced techniques such as short selling and derivatives to manage risk.

These strategies can provide investors with more consistent returns and reduced volatility, but may underperform in strong bull markets.

Relative return strategies aim to outperform a benchmark index, prioritizing the selection of securities that will generate excess returns (often called “tilt” as it tilts the portfolio toward what they believe is likely to outperform).

These strategies can capture higher gains in favorable market conditions but may expose investors to greater market risk and volatility, as they tend to still be very tightly correlated to the index.

Evaluating Portfolio Managers Using Absolute Return vs. Relative Return Metrics

When assessing portfolio managers, investors should consider both absolute and relative return metrics to gain a comprehensive understanding of performance.

Absolute return provides insight into a manager’s ability to generate consistent profits, while relative return measures their skill in outperforming the market.

A balanced approach may involve evaluating managers based on their track record in both categories.

Factors Affecting the Performance of Absolute Return vs. Relative Return Investments

Numerous factors can influence the performance of absolute and relative return investments, including market volatility, interest rates, economic conditions, and the skill of the portfolio manager.

These factors may impact the suitability of an investment strategy for an investor’s specific goals and risk tolerance.

The Role of Asset Allocation in Absolute Return and Relative Return Strategies

Asset allocation plays an important role in managing risk and achieving the desired balance between absolute and relative return strategies.

By diversifying across various asset classes, investors can optimize their exposure to different sources of return (because different asset classes act differently depending on the environment) and reduce the impact of market fluctuations on their overall portfolio performance.

A well-diversified portfolio typically incorporates a mix of absolute return strategies, which offer downside protection and lower volatility, and relative return strategies, which capitalize on market opportunities and generate potential outperformance.

Our look at various popular portfolio approaches (below) and our backtests of them reveal that diverisifcation is a reliable way over time to get more return per unit of risk and lower downside risk:

Implementing Absolute Return and Relative Return Strategies in a Diversified Portfolio

Incorporating both absolute return and relative return strategies into a diversified portfolio requires careful planning and consideration of the investor’s goals, risk tolerance, and time horizon.

A balanced approach might involve allocating a portion of the portfolio to absolute return strategies, such as hedge funds or market-neutral strategies, to provide downside protection and steady returns in various market conditions.

The remaining portion could be dedicated to relative return strategies, such as actively managed equity funds or smart beta strategies, which seek to outperform the market and capture higher returns during favorable market conditions.

By combining these strategies, traders/investors can potentially achieve a more stable and consistent performance, minimizing the impact of market volatility while still benefiting from the potential for outperformance.

However, it is essential for investors to regularly review and adjust their asset allocation to ensure that it continues to align with their objectives and risk tolerance.

When Would a Trader or Investor Care About Absolute Return and When Would They Care About Relative Return?

Absolute Return

A trader or investor would typically care about absolute return when their primary focus is on the actual amount of profit or loss generated by their investment, regardless of how the overall market or a benchmark index performs.

In this context, absolute return represents the actual monetary gain or loss achieved by an investment over a specific period.

Investors who prioritize absolute return are often looking to maximize their profits or minimize losses without necessarily comparing their performance to any external benchmarks.

They may have specific financial goals or targets they want to achieve, such as a certain level of annualized return or a target amount of wealth accumulation.

Hedge funds and other alternative investment strategies often emphasize absolute return, as they aim to generate positive returns in both rising and falling markets.

For example, if “the market” does 30% in one year and they gain 20%, is that a bad thing? It’s still 20%.

If the benchmark falls 30% and they lose 20%, is that a good thing? It’s still a 20% loss.

Moreover, if a trader or investor simply wants to get 2% real (inflation-adjusted) gains per year – i.e., if inflation is 3%, they want at least 5% – they just want to grow their real wealth by a small amount each year. In that case, they don’t care what the index does.

There are also cases of multi-decade bear markets (e.g., Japan) and having less negative returns (“outperform”) won’t mean much to the average trader/investor if their wealth isn’t growing.

Relative Return

On the other hand, investors or fund managers who follow a long-only approach and aim to outperform a benchmark index are often more concerned with relative return.

Relative return measures the performance of an investment or portfolio relative to a specific benchmark or market index.

It indicates whether the investment outperformed or underperformed the broader market or a relevant peer group.

Relative return is commonly used in the context of mutual funds, index funds, and other types of actively managed funds.

Fund managers who benchmark their performance against a specific index, such as the S&P 500 or a sector-specific index, are primarily concerned with generating excess returns compared to that benchmark.

Relative return allows investors to assess whether the fund manager’s stock/asset selection, asset allocation, and timing decisions added value or not.

FAQs – Absolute Return vs. Relative Return

What is the difference between relative return and absolute return?

Absolute return is the return that an asset or portfolio achieves over a certain period, disregarding market conditions.

For instance, if a fund returns 5% in a year, that is its absolute return.

On the other hand, relative return is the return an investment generates compared to a certain benchmark or index.

If the same fund returns 5% in a year, but the benchmark index returns 3%, the fund’s relative return is 2%.

Sometimes absolute returns will be compared relative to inflation (as wealth is not dollar amounts but rather purchasing power).

For example, if a fund returns 5% in a year and the inflation rate was 5%, its real return would be 0%.

How is absolute return different from total return?

Absolute return refers to the gain or loss made by an investment over a period, without considering the performance of the market or any benchmark.

Total return, on the other hand, includes not only the capital appreciation (or depreciation) but also any income generated by the investment, like dividends or interest, over a certain period.

The difference is that total return reflects the total earnings from an investment, whereas absolute return only measures the change in the investment’s value.

What is meant by absolute vs relative performance?

Absolute performance refers to the returns of an investment or portfolio over a set period of time, without considering any benchmark or market index.

Relative performance, on the other hand, compares the returns of an investment to a specific benchmark or market index, often to see how well the investment has performed compared to the general market or its peers.

What is relative return in investment terms?

Relative return is the difference between the return of an investment and the return of a benchmark index.

It is a measure of how an investment or portfolio has performed compared to a standard market index.

For instance, if a mutual fund has a return of 7% for the year and the benchmark index has a return of 5%, the relative return of the mutual fund is 2%.

How is relative return different from excess return?

Excess return is somewhat similar to relative return in that it measures the return of an investment over and above a benchmark or risk-free rate.

However, while relative return is often used to compare an investment to a market index, excess return typically compares an investment’s returns to a risk-free rate of return, such as a Treasury bill.

The idea behind excess return is to evaluate how much more return a trader or investor gets for the additional risk taken when investing in a risky asset.

What is the difference between total return and annualized return?

Total return represents the full return of an investment over a specific period of time, and it includes capital appreciation (or depreciation) and income generated from the investment (such as dividends or interest).

On the other hand, annualized return expresses the return of an investment as an average annual percentage rate.

It enables comparison of returns from different investments or periods by calculating what the return would be if it were achieved consistently each year over the period.

For example, if an investment has doubled in 10 years, you’d say its total return has been 100%. Its annualized return has been about 7% (i.e., 7% compounded over 10 years).

What is absolute return and annualized return in mutual funds?

An absolute return in mutual funds refers to the increase or decrease that a fund has achieved over a certain period, regardless of the market conditions.

It’s solely focused on the returns generated by the fund and does not consider any benchmark or index.

Annualized return, on the other hand, is a method used to calculate the average rate of return earned by the fund per year during the period the money remained in the investment.

It’s a helpful measure because it allows investors to compare the performance of different mutual funds or other types of investments over the same time period.