What Is Absolute Returns?
Absolute returns refer to the total gain or loss an investment or portfolio achieves over a specific period, expressed as a percentage. This straightforward metric, a core concept in investment performance measurement, focuses solely on the growth or decline of the asset itself, independent of external factors or benchmarks. Unlike other performance metrics, absolute returns provide a clear picture of how much money an investor has actually made or lost. They encompass both capital appreciation and any income generated, such as dividends, over the holding period.
History and Origin
While the concept of simply measuring the gain or loss on an investment is as old as investing itself, the formal distinction and emphasis on "absolute returns" as a performance metric gained prominence with the evolution of diversified investment strategies. In earlier eras, investment performance was often implicitly understood as the total percentage change. However, as financial markets grew more complex and the industry introduced various investment vehicles and management styles, the need to compare performance became crucial. The explicit focus on absolute returns intensified particularly with the rise of alternative investments, such as hedge funds, which often aim to generate positive returns regardless of overall market conditions. This contrasted sharply with traditional fund managers who were primarily judged on how well they performed relative to a specific benchmark. The Securities and Exchange Commission (SEC) has also provided guidance on performance reporting for investment advisers, emphasizing transparency in presenting both gross and net performance figures, which naturally aligns with the clarity provided by absolute return calculations.4
Key Takeaways
- Absolute returns measure the total percentage gain or loss of an investment or portfolio over a defined period.
- This metric is independent of any benchmark, market index, or comparison to other investments.
- It provides a clear, uncontextualized view of the actual wealth generated or lost by an investment.
- Absolute returns are crucial for investors focused on achieving specific financial goals, rather than merely outperforming a market index.
- Both positive and negative outcomes are expressed as absolute returns.
Formula and Calculation
The calculation for absolute returns is straightforward, representing the percentage change in value from the beginning to the end of a period.
The formula for absolute returns is:
Where:
- Ending Value: The value of the investment or portfolio at the end of the specified period, including any income generated (e.g., dividends).
- Beginning Value: The initial value of the investment or portfolio at the start of the specified period.
For example, if an investment starts at $10,000 and ends at $11,500 after one year, including any distributed dividends, the absolute return is:
This indicates a 15% absolute return.
Interpreting the Absolute Returns
Interpreting absolute returns involves understanding the raw performance of an asset. A positive absolute return indicates a profit, while a negative absolute return signifies a loss. Unlike risk-adjusted returns, absolute returns do not account for the amount of risk taken to achieve that return. For example, an investment with a 20% absolute return may seem impressive, but without knowing the associated volatility or the broader market's performance, it is difficult to fully assess the quality of that return.
Investors often use absolute returns when their primary concern is meeting a specific financial target or achieving a positive return regardless of market conditions. For instance, a retiree living off their portfolio might prioritize a consistent, positive absolute return to cover living expenses, rather than aiming to beat the S&P 500 by a few percentage points.
Hypothetical Example
Consider an investor, Sarah, who purchased 100 shares of Company X stock at $50 per share on January 1st, for a total initial investment of $5,000. Over the year, Company X distributed $1.00 per share in dividends. By December 31st, the stock price had risen to $57 per share.
To calculate Sarah's absolute return:
- Beginning Value: 100 shares * $50/share = $5,000
- Ending Value (from capital appreciation): 100 shares * $57/share = $5,700
- Total Dividends Received: 100 shares * $1.00/share = $100
- Total Ending Value (including dividends): $5,700 + $100 = $5,800
Now, apply the absolute return formula:
Sarah achieved a 16% absolute return on her investment in Company X over the year. This figure tells her precisely how much her initial capital grew, irrespective of how other stocks or the overall market performed during that period.
Practical Applications
Absolute returns are widely used across various facets of finance for assessing the raw performance of an investment. In portfolio management, it is the most direct measure of an investor's profit or loss. For example, a mutual fund may highlight its absolute returns over different periods to demonstrate its historical performance to potential investors.
It is particularly relevant in the context of "absolute return strategies" employed by certain funds, which aim to deliver positive returns regardless of broader market movements. These strategies often involve specialized techniques like short selling, using futures contracts, options trading, derivatives, and arbitrage to generate returns from various market conditions.
Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), also require investment advisers to present performance information clearly and transparently, often requiring the disclosure of both gross and net absolute returns to facilitate comparison and avoid misleading advertisements.3 For individual investors, absolute returns are essential for understanding the progress toward personal financial goals, such as saving for retirement or a down payment on a house, where the ultimate dollar amount gained or lost is the primary concern.
Limitations and Criticisms
While seemingly straightforward, relying solely on absolute returns has significant limitations. Firstly, absolute returns provide no context for the risk taken to achieve them. A high absolute return might have been generated by taking on excessive risk, which could lead to substantial losses in the future. Conversely, a modest absolute return might be excellent if it was achieved with very low risk. Academic research highlights that investment performance measurement should consider both returns and the associated risk.2
Secondly, absolute returns offer no insight into how an investment performed relative to the broader market or comparable investments. For example, an investment that yields a 5% absolute return in a bull market where the overall market gained 20% might be considered underperforming. Conversely, a 5% absolute return during a significant market downturn (e.g., when the S&P 500 loses 15%) would be considered exceptional. As one analysis points out, judging performance based on absolute returns alone can be misleading without market context.1 Without a benchmark, it is impossible to determine if a manager added value beyond what the market would have provided.
Finally, absolute returns do not inherently account for inflation. A positive nominal absolute return might still result in a loss of purchasing power if the inflation rate was higher than the investment's return. Therefore, for long-term investing, considering inflation-adjusted returns is often more meaningful.
Absolute returns vs. Relative returns
The primary distinction between absolute returns and relative returns lies in their point of comparison. Absolute returns quantify the total percentage gain or loss of an investment over a period, independently of any other investment or market index. It is the actual, unadjusted return realized by the investor. For example, if an asset increases from $100 to $110, its absolute return is 10%.
In contrast, relative returns measure an investment's performance against a specific benchmark or market index, such as the S&P 500 or a peer group average. It indicates whether an investment has outperformed or underperformed its chosen standard. If the aforementioned asset returned 10%, but its benchmark index returned 12% over the same period, its relative return would be -2% (underperforming the benchmark). Investment professionals often use relative returns to gauge the effectiveness of an active management strategy or to assess how well a portfolio is performing compared to its market segment. While absolute returns tell you how much money you made, relative returns tell you how well you performed compared to expectations or the market.
FAQs
1. Are absolute returns always positive?
No, absolute returns can be positive (a gain) or negative (a loss). They simply represent the total percentage change in an investment's value, whether it went up or down.
2. Why is it important to know absolute returns?
Knowing absolute returns is important because it tells you the exact percentage by which your initial capital has grown or shrunk. This is fundamental for evaluating the direct financial outcome of an investment and for assessing progress towards specific financial goals that are not tied to market benchmarks.
3. Do absolute returns consider fees?
Absolute returns can be calculated both before and after fees. For investors, the most relevant measure is typically the net absolute return, which reflects the actual return after all expenses and commissions have been deducted. Fund managers often report gross absolute returns to show performance before their management fees, but regulatory guidelines usually require disclosure of net returns as well.
4. Can absolute returns be annualized?
Yes, absolute returns can be annualized, especially for periods longer than one year, to provide a consistent basis for comparison. Annualizing helps to understand the average yearly growth rate over a multi-year period, assuming compounding. However, it's important to note that an annualized absolute return is a geometric average, not a simple average, and assumes consistent growth over the period.
5. When is absolute return more relevant than relative return?
Absolute return is more relevant when an investor's primary objective is to achieve a specific positive return or to preserve capital, regardless of market performance. This is common for investors with specific spending needs or those who prioritize downside protection over outperforming a benchmark. For example, a pension fund might target a 7% absolute return annually to meet its future liabilities, rather than simply aiming to beat a stock market index, especially if that index might experience significant downturns.