Absolute return: Meaning, Criticisms & Real-World Uses

What Is Absolute Return?

Absolute return refers to the appreciation or depreciation an asset or portfolio achieves over a specified period, expressed as a percentage. This metric focuses solely on the gain or loss of an investment without comparing it to any external benchmark or market index. Absolute return is a key concept within the broader realm of investment strategy, offering a direct measure of an investment's stand-alone performance. It forms a core component of how certain investment vehicles, particularly hedge funds, evaluate their success. Unlike traditional fund managers who often aim to outperform a market index, managers focused on absolute return strive for positive returns regardless of market direction¹⁴.

History and Origin

The concept of actively managed funds seeking to generate positive returns irrespective of market conditions gained prominence with the establishment of the first absolute return fund. This pioneering fund was formed in New York in 1949 by Alfred Winslow Jones, who is widely credited with originating the hedge fund structure. His innovative approach, focused on hedging market risk to achieve positive returns, laid the groundwork for what would become known as "absolute return" strategies. In recent decades, the absolute return approach to fund investing has seen significant growth and is now more commonly associated with hedge funds and other alternative investment vehicles¹³.

Key Takeaways

Absolute return measures the total percentage gain or loss of an investment over a specific period, independent of market movements or benchmarks.
It is particularly relevant for strategies like those employed by hedge funds, which aim for positive returns in all market environments.
Unlike relative return, absolute return does not compare an investment's performance against an index or peer group.
The primary goal of an investment pursuing an absolute return strategy is to deliver positive returns consistently, often with an emphasis on limiting volatility.
Evaluating absolute return helps investors understand the stand-alone profitability of an investment.

Formula and Calculation

The calculation of absolute return is straightforward, reflecting the total percentage change in an investment's value over a given period. It does not account for the duration of the investment.

The formula for absolute return is:

\text{Absolute Return} = \frac{\text{Final Value} - \text{Initial Value}}{\text{Initial Value}} \times 100\%

Where:

Final Value = The value of the investment at the end of the period.
Initial Value = The amount initially invested or the value of the investment at the beginning of the period.

This formula provides a clear picture of the return on investment without external comparisons¹².

Interpreting the Absolute Return

Interpreting absolute return involves assessing the direct gain or loss an investment has generated. A positive absolute return indicates a profit, while a negative absolute return signifies a loss. Unlike relative return, which compares performance against a market benchmark, absolute return is evaluated on its own merits. For instance, an absolute return of +5% means the investment grew by 5%, irrespective of whether the broader market was up 20% or down 10% during the same period. Investors utilize absolute return to understand the independent performance of an asset or fund, especially in the context of strategies designed to be uncorrelated with overall market trends. This perspective is crucial for effective portfolio management when the goal is consistent positive gains rather than outperforming an index¹¹.

Hypothetical Example

Consider an investor, Sarah, who purchased shares in a technology company.

Initial Investment: Sarah bought 100 shares at $50 per share, totaling an initial investment of $5,000.
Investment Period: After six months.
Final Value: The shares are now worth $55 per share, making her investment's current value $5,500.

To calculate the absolute return:

\text{Absolute Return} = \frac{\$5,500 - \$5,000}{\$5,000} \times 100\%

\text{Absolute Return} = \frac{\$500}{\$5,000} \times 100\%

\text{Absolute Return} = 0.10 \times 100\%

\text{Absolute Return} = 10\%

In this hypothetical example, Sarah achieved an absolute return of 10% on her investment over six months, demonstrating a direct capital appreciation. This calculation helps her understand the direct profitability of her stock purchase.

Practical Applications

Absolute return is a fundamental metric with several practical applications across various financial domains. In portfolio management, it is often the direct measure of success for strategies that prioritize generating positive returns in all market conditions, rather than simply outperforming a market index. This is particularly true for hedge funds, which explicitly aim for positive absolute returns through diverse and often complex strategies.

These strategies may involve the use of financial instruments such as derivatives, short selling, leverage, and arbitrage to generate gains independent of market direction. For example, a hedge fund manager might utilize short selling to profit from declining asset prices, aiming to achieve a positive absolute return even in a bear market¹⁰. The U.S. Securities and Exchange Commission (SEC) provides guidance on various investment vehicles, including mutual funds and hedge funds, noting the distinct characteristics of each⁹.

Limitations and Criticisms

While absolute return offers a clear, stand-alone measure of an investment's performance, it has certain limitations and has faced criticisms. One significant drawback is that it does not account for the time horizon over which the return was generated. A 10% absolute return over one month is very different from a 10% absolute return over five years, yet the simple absolute return calculation does not distinguish this. This can make comparing investments with different holding periods misleading.

Furthermore, absolute return does not inherently incorporate risk management. A high absolute return could have been achieved by taking on excessive risk. Investors must consider the volatility and risk taken to achieve the return, as a strategy might generate positive absolute returns in favorable conditions but suffer significant losses when markets turn. For instance, some absolute return funds have struggled to deliver consistent positive returns, particularly during periods of market distress, and have shown higher correlations to traditional markets than often claimed⁸. HFR, a global hedge fund research firm, defines absolute return funds as aiming for "steady, positive returns in all market environments," but the actual performance can vary⁷.

Absolute Return vs. Relative Return

The distinction between absolute return and relative return is crucial in investment analysis. Absolute return focuses solely on the total percentage gain or loss of an investment over a period, without any comparison to external factors. It answers the question, "How much did my investment make (or lose)?" For example, if an investment goes from $100 to $110, its absolute return is 10%.⁶.

In contrast, relative return measures an investment's performance against a specific benchmark, such as a market index (e.g., S&P 500) or a peer group. It answers the question, "How did my investment perform compared to X?" If the same investment yields a 10% absolute return, but the benchmark gained 15%, the relative return is -5% (underperformance). Conversely, if the benchmark lost 5%, the relative return is +15% (outperformance). The confusion often arises because both metrics discuss investment returns, but their contextual framework for evaluation differs fundamentally⁵. Relative return provides context regarding market trends, while absolute return gives a straightforward measure of profit or loss, regardless of what the market or peers did⁴.

FAQs

What does "absolute return" mean in simple terms?

Absolute return is simply the total profit or loss an investment made, expressed as a percentage, without comparing it to anything else. If you invested $100 and it grew to $108, your absolute return is 8%.

When is absolute return most useful?

Absolute return is most useful when you want to know the direct gain or loss of a specific investment over any period, especially short periods (less than a year), or when evaluating investment strategies that aim to make money regardless of overall market direction, such as certain hedge funds ², ³.

Does absolute return consider risk?

No, the raw absolute return calculation does not account for the risk management taken to achieve that return. A high absolute return could come with significant volatility, meaning the investment's value fluctuated wildly during the period. Investors need to consider risk separately when evaluating performance.

How is absolute return different from annualized return?

Absolute return shows the total gain or loss over a specific period, regardless of its length. Annualized return, on the other hand, converts the investment's performance to an annual rate, making it easier to compare investments held for different durations, especially those longer than one year¹.

Are absolute return funds a safe investment?

Not necessarily. While "absolute return" funds often aim for positive returns in all market conditions, this does not guarantee safety or positive outcomes. They frequently employ complex strategies, including leverage and short selling, which can involve significant risks. Investors should always understand the underlying investment strategy and potential risks before investing.