Relative return: Meaning, Criticisms & Real-World Uses

What Is Relative Return?

Relative return is a measure of an investment's or portfolio's investment performance compared to a specific benchmark index or a peer group. It falls under the broader umbrella of portfolio theory, providing context beyond just the absolute gain or loss. Unlike simply looking at how much an investment has grown, relative return indicates how well an investment has performed in comparison to what it was expected to, or how it stacked up against similar investments or a relevant market segment. Understanding relative return is crucial for evaluating the effectiveness of an investment strategy, especially for professionally managed funds.

History and Origin

The concept of evaluating investment performance relative to a benchmark has evolved alongside the increasing sophistication of financial markets and the growth of the asset management industry. In earlier periods, simply achieving a positive absolute return was often the primary focus. However, as capital markets expanded and diverse investment opportunities emerged, investors and fund managers alike recognized the need for a more nuanced assessment.

The formalization of benchmark-centric performance evaluation gained significant traction in the latter half of the 20th century. The rise of institutional investors, mutual funds, and pension funds necessitated clear metrics to compare the success of various portfolio management strategies. Academics and practitioners began developing methodologies to quantitatively compare a portfolio's returns against appropriate market indices, leading to the widespread adoption of relative return as a key performance indicator. This shift also coincided with the development of modern portfolio theory, which emphasizes the importance of diversification and understanding risk-adjusted returns relative to market factors. The Securities and Exchange Commission (SEC) later enacted rules, such as Rule 206(4)-1 under the Investment Advisers Act of 1940, to govern how investment advisers advertise their performance, including presentations of relative returns, ensuring disclosures are clear and not misleading.³, ⁴, ⁵

Key Takeaways

Relative return measures an investment's performance against a chosen benchmark or peer group.
It is critical for evaluating active management strategies and assessing how well a fund manager performed against their stated objectives.
A positive relative return, or outperformance, means the investment performed better than its benchmark.
A negative relative return, or underperformance, means the investment performed worse than its benchmark.
Relative return provides context by considering market conditions and the performance of comparable assets.

Formula and Calculation

The calculation of relative return is straightforward, involving the difference between the return of the investment and the return of its benchmark.

\text{Relative Return} = \text{Investment Return} - \text{Benchmark Return}

Where:

Investment Return: The percentage gain or loss of the investment or portfolio over a specific period.
Benchmark Return: The percentage gain or loss of the chosen benchmark index over the same specific period.

For example, if a mutual fund's return over a year was 12%, and its benchmark index (e.g., the S&P 500) returned 10% over the same period, the relative return would be:

\text{Relative Return} = 12\% - 10\% = 2\%

This indicates that the fund outperformed its benchmark by 2 percentage points.

Interpreting the Relative Return

Interpreting relative return involves understanding the implications of outperformance or underperformance. A positive relative return signifies that an investment has "beaten the benchmark," suggesting successful active management or a favorable asset allocation strategy compared to the market segment represented by the benchmark. Conversely, a negative relative return means the investment has "lagged the benchmark."

This measure is particularly relevant for active investors and fund managers who aim to generate alpha, which is the excess return of a portfolio relative to the return of a benchmark index. For investors evaluating a professionally managed fund, consistently positive relative returns over various market cycles could indicate skill in stock selection or market timing. However, it's also important to consider the associated risk taken to achieve that relative return, as higher returns might come with greater market volatility.

Hypothetical Example

Consider an investor, Sarah, who owns shares in a technology-focused mutual funds. The fund's primary benchmark is the NASDAQ 100 Index.

At the end of the year, Sarah reviews her investment:

Fund Performance: Her technology fund generated a return of 18% for the year.
Benchmark Performance: The NASDAQ 100 Index returned 20% over the same period.

To calculate the relative return:

\text{Relative Return} = \text{Fund Return} - \text{Benchmark Return}

\text{Relative Return} = 18\% - 20\% = -2\%

In this scenario, despite the technology fund generating a positive 18% return, its relative return is -2%. This indicates that the fund underperformed its specific technology-focused benchmark by 2 percentage points. For Sarah, this suggests that while her investment grew, it did not perform as well as the broader market segment it aims to track. This information is crucial for her to assess the fund manager's effectiveness and decide if the fund aligns with her diversification goals.

Practical Applications

Relative return is a cornerstone of performance evaluation across various segments of the financial industry. In the realm of portfolio management, investment managers often have their compensation tied to how well they perform against a benchmark through performance fees. This incentivizes them to outperform the market. For instance, hedge funds and actively managed mutual funds frequently advertise their relative returns to attract investors, showcasing their ability to generate alpha.

Regulators, such as the SEC, also emphasize transparent and fair presentation of investment performance, including relative returns, in advertisements to protect investors from misleading information. The SEC's guidance on Investment Adviser Marketing outlines the conditions under which performance results, including hypothetical and extracted performance, can be presented. This ensures that investors receive sufficient information to understand the risks and limitations associated with reported returns. Investors use relative return to compare similar investment products, such as two different large-cap growth funds, to determine which manager has demonstrated superior skill in a given market environment. It helps them differentiate between a fund that simply benefited from a rising market (high absolute return) and one that added value by truly outperforming its peers or a passive alternative.

Limitations and Criticisms

While valuable, relative return has its limitations and has drawn criticism. A primary concern is that focusing solely on relative return can lead to "benchmark hugging," where fund managers prioritize staying close to their benchmark to avoid significant underperformance, rather than pursuing potentially higher-returning but more divergent strategies. This behavior, sometimes referred to as "herding," can result in portfolios that closely mimic the benchmark, reducing the true value proposition of active management. Academic research highlights how elements of relative performance evaluation in fund manager contracts can bias them to deviate from return-maximizing allocations and instead follow their benchmark.²

Furthermore, an overemphasis on relative return can sometimes lead to excessive risk-taking if managers attempt to recover from underperformance by making aggressive, speculative bets to catch up to their benchmark. This can result in unintended exposures and potentially significant losses. Some studies suggest that while performance evaluation is efficient for disciplining managers, it can also cause "runs" by fund managers and lead to asset fire sales, indicating a need for optimal evaluation to combine both absolute and relative components to mitigate such risks.¹ Another critique is the choice of benchmark itself. An inappropriate or poorly chosen benchmark can distort the perception of relative return, making a fund appear to outperform or underperform when the comparison is not truly apples-to-apples. This can complicate the evaluation of a fund's actual skill or contribution. This also underscores the importance of considering whether a passive management approach, which aims to match the benchmark's performance, might be more cost-effective.

Relative Return vs. Absolute Return

The distinction between relative return and absolute return is fundamental in investment analysis. Absolute return measures the total gain or loss of an investment or portfolio over a specified period, expressed as a percentage. It is a standalone figure, showing how much an investment has increased or decreased in value, without reference to any external factor. For example, if an investment grows from $100 to $110, its absolute return is 10%.

In contrast, relative return provides context by comparing that 10% gain to a specific benchmark index or a peer group. If the benchmark returned 8% over the same period, the relative return would be 2% (10% - 8%), indicating outperformance. If the benchmark returned 12%, the relative return would be -2% (10% - 12%), indicating underperformance. While absolute return tells an investor how much money they made or lost, relative return tells them how well their investment performed compared to something else. Investors often look at both measures: absolute return to understand the direct financial outcome and relative return to gauge the effectiveness of an investment strategy against market opportunities or peer performance. The confusion between the two often arises when investors conflate a positive absolute return with a successful strategy, without considering whether market conditions could have yielded an even higher return with a different approach.

FAQs

Why is relative return important for investors?

Relative return is important because it provides a contextual understanding of an investment's performance. It helps investors assess whether a fund manager's decisions added value (outperformance) or detracted from it (underperformance) compared to a relevant market standard or the performance of other similar funds. This is crucial for evaluating active management strategies and making informed decisions about where to allocate capital.

Can a fund have a positive absolute return but a negative relative return?

Yes, this is entirely possible and a common scenario. For example, if a fund earns a 5% absolute return in a booming market, but its benchmark index surges by 10% during the same period, the fund would have a negative relative return of -5% (5% - 10%). This means that while the investor's money grew, it did not keep pace with the broader market or its intended comparison.

What is a good relative return?

A "good" relative return is generally considered to be consistently positive, indicating that an investment or fund has outperformed its chosen benchmark. However, what constitutes "good" also depends on the level of risk taken to achieve that outperformance, the fees charged, and the consistency of the performance over various market cycles. A fund that consistently beats its benchmark by a small margin with lower risk might be preferred over one that occasionally achieves large outperformance but with significant volatility.

How do fund managers use relative return?

Fund managers use relative return as a key metric to evaluate their own investment performance and to report to clients and stakeholders. Their compensation, often including performance fees, may be tied to achieving positive relative returns. It influences their portfolio construction, risk management, and overall investment strategy as they strive to outperform the benchmarks associated with their mandates.