What is the difference between absolute return and relative return?

Faced with a catalog full of instruments subject to low interest rates, obtaining an attractive return on investment seems like an impossible mission. Think that, in order to get the most out of your money, you need to analyze whether the return on investment will be equal to or greater than annual inflation, for example. This applies to everything, Money Market Accounts, your savings accounts and the retirement plans.

So how can you tell if your fund manager, broker or fund manager is doing a good job? In part, knowing what is the difference between absolute return and relative return. Why? Mainly because this data will help you understand how performance is measured and how this percentage translates into profit.

What is absolute return?

The performance or absolute return is nothing more than a measurement that calculates how much extra money an asset or investment portfolio has generated in a given period of time. This leads many to believe that absolute performance alone does not say much, since relative performance must also be looked at. Think that only then will you know how your investment compares -and the profits you obtained- with similar ones.

Once you have that reference point, then you can measure what the real return on your investment was. This will allow you to decide if you should continue in the background or, on the contrary, you should look for another alternative. It is important that you take into account that the fund managers that measure your performance in absolute terms have the objective of diversifying the investment in different types of assets at a national and international level.

In addition, these managers pay special attention to the correlation that exists between the different components of your portfolio. The goal itself is not be subject to the wild swings of the market that occur before wars, economic crises, among other events.

Absolute return funds are designed to earn positive returns. How do they do that? Through the use of techniques that differ from those implemented in traditional investment funds. Absolute return fund managers use modalities such as short sales, futures, leverage, and investing in unconventional assets.

Investment performance is analyzed on its own terms, that is, separated from other measures of performance, such as the most popular benchmarks in the country. In itself, it could be said that the administrators of this type of fund take advantage of short-term market swingsregardless of whether they buy long or short.

What is relative return?

The return or relative return is the difference between the absolute return and the return of the market or other similar investments. To get this percentage, managers compare an investment’s absolute return to a benchmark index, such as the S&P 500. This type of return is also known as alpha.

What is the importance of relative return?

It is a way of measuring the return of the managed funds to know if it obtained a return equal to, less than or greater than that reported by the market. This would give you an opportunity to know if your fund manager is doing a good job or a bad job.

For example, an investor could participate in an index fund that has a low expense ratio – called MER – and thus ensure that they obtain the return of the market.

Note: If an investor is paying their manager to offer a better return than the market, but instead notices that the return is not positive and this situation continues for a long period of time, it should be changed from administrator as soon as possible.

Many of the fund managers who are guided by relative performance tend to rely on some practices and trends that have proven to be successful in the market, since -in their opinion- this will allow them to generate a much higher yield. To do this, they carry out a global and detailed analysis that will allow them to determine where to invest for -at least- one or more years.

In summary

Absolute return mutual funds have one goal: to obtain a positive return, regardless of the fluctuations that occur in the market. This forces them to set their own level of risk, which is usually low. Why? Because the main objective, above all, is to preserve the capital of investors. Therefore, both their investment policies and the markets in which they invest are different from those of other funds.

Relative return example

If a quick reading of the market indicates that a stock will rise, the manager will buy the stock long. If the market starts to drop sharply, then you will be shorting. This is complemented by risk diversification, thus building a heterogeneous investment portfolio that allows them to weigh the losses that an asset shows, in the event that this occurs.

What is the difference between absolute return and relative return?

One of the best ways to see the difference between absolute return and relative return is using the context of the market itself, that is, the fight between the bulls and the bears in the stock market. In a bull market, a 2% return would be seen as poor performance, as it could be so much more, right? But in a bear market – when many investments fall by as much as 20% – preserving principal intact would be seen as a win. If under these conditions an investment obtains a 2% return, it would be even better! At least when compared to the current situation in that market.

In this example above, that 2% would be the absolute return. If your mutual fund returned 8% to you last year, then that 8% would be your absolute return. So far, everything remains pretty clear. Now, let’s move on to the relative return: this measure is precisely the one that would tell you that that 2% profit in a bull market is a terrible figure, but that it would be desirable in a bear market.

How do you come to that conclusion? Because that 2% is compared with the benchmark indices. If you made 2% with your fund while everyone else fell by 10% and 20%, you made a lot of money and went against the market trend!

As you can see, what matters in the relative return is not the performance itself, but the belief that the positive (appreciation) or negative (depreciation) of your performance is relative: everything will depend on how it compares with the market in general.

In short, difference between absolute return and relative return

Absolute return is what an asset or fund has generated, that is, what it returned to you in interest over a certain period of time. Relative return is the return an asset or fund earned over a given time compared to a market benchmark.

Managers and administrators of absolute return investment funds focus on achieving short term results taking advantage of the oscillations of the market, while the managers and administrators of relative return funds set their objectives following a much bigger picture.

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