Relative performance

What Is Relative Performance?

Relative performance, within the realm of Investment Analysis, measures an investment's or portfolio's return compared to that of a specific benchmark or a peer group. Unlike absolute performance, which focuses solely on the total return generated, relative performance provides context by indicating how well an investment has performed against a relevant standard. This metric is crucial for evaluating the effectiveness of an investment strategy and assessing the skill of a portfolio manager. It helps investors understand whether their investments are exceeding, meeting, or trailing the returns of a comparable market segment or set of competing funds.

History and Origin

The concept of comparing investment returns to a standard has roots in the evolution of modern portfolio management. As financial markets grew more complex and the number of investment vehicles expanded, investors and fiduciaries needed a way to gauge success beyond simple gains or losses. The formalization of market indices, such as the S&P 500 (which launched in its current form in 1957), provided widely accepted benchmarks against which performance could be measured. This led to the widespread adoption of relative performance as a key evaluative tool, particularly with the rise of institutional investing and the proliferation of professionally managed funds. The ongoing debate between active management and passive investing further underscored the importance of relative performance, as it directly addresses whether active strategies can consistently outperform their chosen benchmarks.

Key Takeaways

• Relative performance assesses an investment's returns against a benchmark or peer group.
• It provides context beyond simple gains, indicating outperformance or underperformance.
• Relative performance is fundamental for evaluating investment strategies and portfolio manager skill.
• The choice of an appropriate benchmark is critical for meaningful relative performance analysis.
• It is a core concept in performance attribution, explaining sources of return differences.

Formula and Calculation

Calculating relative performance involves a straightforward comparison of returns. While there isn't a single "formula" for relative performance itself, it is derived by comparing the return on investment of a portfolio to that of its chosen benchmark or the average of its peer group over the same period.

The difference, often called "excess return" or "alpha," can be expressed as:

For example, if a portfolio generated a return of 10% and its benchmark returned 8% over the same period, the relative performance would be +2%. Conversely, if the portfolio returned 6% against an 8% benchmark, the relative performance would be -2%.

This simple calculation forms the basis for more sophisticated risk-adjusted return metrics like alpha and beta, which also consider the level of risk taken to achieve those returns.

Interpreting the Relative Performance

Interpreting relative performance requires a deep understanding of the investment's objectives and the chosen benchmark. A positive relative performance indicates that the investment has outperformed its standard, suggesting effective fund performance or skilled management. Conversely, negative relative performance means underperformance. However, context is vital. For instance, a fund might have negative absolute returns but still exhibit strong relative performance if the benchmark experienced an even larger decline.

Investors should consider the consistency of relative performance over various time horizons, as short-term outperformance can be coincidental. It is also important to scrutinize the appropriateness of the benchmark itself. A mismatch between the investment's characteristics and the benchmark's composition can lead to misleading relative performance figures.

Hypothetical Example

Consider an investor, Sarah, who holds a large-cap U.S. equity fund. Her fund's primary objective is to outperform the S&P 500 market index.

At the end of the year, Sarah checks her statements:

• Her fund's return for the year: +12.5%
• S&P 500 index return for the year: +10.0%

To calculate the relative performance of her fund:

In this scenario, Sarah's fund demonstrated positive relative performance of 2.5%, indicating that her investment manager successfully added value beyond simply tracking the broad market. If the fund's return had been 9.0%, its relative performance would have been -1.0%, signifying underperformance against its benchmark.

Practical Applications

Relative performance is a cornerstone in many areas of finance. For professional investors, it is critical for performance attribution, helping them pinpoint whether their outperformance (or underperformance) came from security selection, sector allocation, or other factors. Investment managers frequently use relative performance to demonstrate their value proposition to clients and justify their fees, such as the expense ratio.

Regulators, like the U.S. Securities and Exchange Commission (SEC), also pay close attention to how investment performance, including relative performance, is presented to the public. The SEC's Marketing Rule, for example, sets guidelines for how investment advisers can advertise performance, aiming to ensure that disclosures are fair and balanced, especially when presenting past results or comparing them to benchmarks.³

For individual investors, understanding relative performance helps in making informed decisions about fund selection, particularly when choosing between actively managed funds and index funds. Morningstar's Active/Passive Barometer, a semiannual report, frequently highlights the challenge many active funds face in consistently outperforming their passive counterparts over longer periods, underscoring the significance of relative performance in the active vs. passive debate.²

Limitations and Criticisms

Despite its widespread use, relative performance has several limitations. One significant critique revolves around "benchmark hugging," where portfolio managers may shy away from significant deviations from the benchmark, even if they believe it's the optimal strategy, to avoid the risk of severe underperformance. This can stifle true diversification and innovative investment approaches.

Another limitation is the potential for an inappropriate benchmark. If a benchmark does not accurately reflect the investment universe or strategy of a fund, the relative performance metric can be misleading. For instance, a fund investing in small-cap growth stocks should not be solely judged against a broad large-cap index. Experts like Research Affiliates have highlighted the "benchmark puzzle," arguing that some traditional benchmarks may constrain managers and lead to suboptimal portfolio construction.¹ Furthermore, reliance on relative performance can lead to excessive focus on short-term results, as managers may prioritize beating their benchmark quarter-to-quarter rather than focusing on long-term capital appreciation for clients. This can encourage risk-taking that is not aligned with investor objectives.

Relative Performance vs. Absolute Performance

Relative performance and absolute performance are two distinct yet complementary ways to evaluate investment returns.

Absolute performance measures the total gain or loss of an investment over a specific period, expressed as a percentage. It answers the question: "How much did my investment grow (or shrink)?" An investment that started at $100 and ended at $110 has an absolute performance of +10%, regardless of market conditions. This metric is essential for investors who prioritize the raw return on their capital.

Relative performance, in contrast, assesses an investment's return compared to an external standard, typically a benchmark or a peer group. It answers the question: "How well did my investment perform compared to X?" If the market benchmark gained 8% while the investment gained 10%, its relative performance is +2%. The confusion often arises because a positive absolute return can still be considered underperformance if the benchmark significantly outpaced it, and vice versa. While absolute performance shows the actual profit or loss, relative performance provides critical context by showing how that profit or loss stacks up against comparable alternatives.

FAQs

Why is relative performance important?

Relative performance is important because it provides context for an investment's returns. It helps investors and managers understand whether an investment is performing better or worse than a relevant market standard or a group of similar investments.

Can an investment have positive absolute performance but negative relative performance?

Yes, this is possible. If an investment generates a positive return (e.g., 5%) but its chosen benchmark or peer group yields an even higher return (e.g., 8%), then the investment has positive absolute performance (+5%) but negative relative performance (-3%).

How is a benchmark chosen for relative performance?

A benchmark is typically chosen to reflect the investment's style, asset class, and risk profile. For example, a large-cap U.S. equity fund might use the S&P 500, while a global bond fund might use a broad-based global bond index. The goal is to pick a benchmark that provides a fair comparison.

Does relative performance consider risk?

The basic calculation of relative performance (Portfolio Return - Benchmark Return) does not explicitly consider risk. However, more advanced performance metrics such as Sharpe Ratio or Information Ratio build upon the concept of excess return to evaluate risk-adjusted relative performance.

Is it always better to have positive relative performance?

Generally, positive relative performance indicates outperformance against a standard, which is desirable. However, it's important to consider the overall market environment and the objectives of the investment. In a severe market downturn, an investment might still be considered successful if it loses less than its benchmark, even if its absolute return is negative.