Absolute Return vs Relative Return Key Differences Explained

Absolute return and relative return help in understanding how the overall market or comparable investments are performing.

Absolute Return

This refers to the total return an asset or portfolio generates over a specific period, without comparing it to any benchmark or index. Absolute return managers design diversified portfolios, spanning asset classes, regions, and economic cycles, to reduce exposure to market volatility. Their strategies often include:

• Short selling, futures, options, and derivatives.
• Arbitrage, leverage, and alternative investments.

The goal of absolute return funds is to achieve positive returns regardless of market conditions, focusing on profits or losses independently of external benchmarks. These managers generally operate with a short-term horizon, relying on price swings and avoiding dependency on long-term market trends.

Absolute return alone doesn’t provide sufficient context. To gauge whether an investment is performing well or poorly, it is necessary to compare its return to similar investments or benchmarks, i.e., consider its relative return.

Relative Return

Relative return measures the performance of an investment against a benchmark, such as the S&P 500, and is also known as alpha. It represents the difference between the absolute return and the benchmark return.

Relative return is vital for assessing the performance of actively managed funds. Unlike passive investments (e.g., index funds) that aim to match market returns, actively managed funds should ideally outperform the market. For example: An investor paying higher fees for active management expects returns greater than the benchmark over the long term.

If a fund manager underperforms compared to the market for an extended period, it may signal the need to switch to another manager or investment strategy. Relative return managers often analyze global economic trends and specific companies, aiming to generate returns over a longer timeline, typically a year or more.

Absolute vs. Relative Return in Different Market Cycles

Consider a scenario during a market cycle:

• In a bull market (rising market), a 2% return would seem underwhelming, as the broader market may have returned significantly more.
• In a bear market (declining market), a 2% return could be seen as a success, especially if most investors suffered losses of 20% or more.

Here, the absolute return is 2%, but the relative return determines how good or bad that 2% is in context. Relative return shows that preserving capital in a bear market is an achievement, while the same return during a bull market indicates underperformance.

Bottom Line

Absolute return measures raw performance, while relative return provides critical context by comparing returns to a benchmark. Understanding the difference helps investors assess fund managers more effectively and make better investment decisions based on their goals and market conditions.