What Is Relative Returns?
Relative returns measure the gain or loss of an investment or portfolio compared to a specific benchmark or index over a given period. It is a key metric within investment performance analysis, providing context beyond just the absolute growth of capital. Rather than focusing solely on the direct profit or loss, relative returns assess how an investment fares against a relevant market standard, such as a stock market index, a peer group of funds, or a custom-defined target. This comparison helps investors and portfolio managers evaluate the effectiveness of an investment strategy and understand whether they are outperforming or underperforming the market or their competitors.
History and Origin
The concept of relative returns gained prominence with the increasing institutionalization of investment management and the widespread adoption of financial benchmarks. While investors have always informally compared their results, the formalization of benchmarks like the S&P 500 index provided a standardized yardstick for evaluating performance. The S&P 500, for instance, was introduced in 1957 as a stock market index to track the value of 500 leading U.S. corporations, evolving from earlier, smaller indexes., This provided a widely accepted measure against which professional money managers could compare their own portfolio management capabilities. The rise of index fund investing further solidified the importance of relative returns, as it offered investors a low-cost way to achieve market returns, making outperforming the benchmark a clearer goal for active management strategies.
Key Takeaways
- Relative returns measure an investment's performance against a specific benchmark or market index.
- They provide crucial context, indicating whether an investment is outperforming or underperforming its peers or the broader market.
- Relative returns are essential for evaluating the skill of portfolio managers and assessing the efficacy of an investment strategy.
- Fund managers often aim to generate positive relative returns, which means beating their chosen benchmark.
- Understanding relative returns helps in making informed decisions about asset allocation and manager selection.
Formula and Calculation
The calculation for relative returns involves comparing the total return of an investment or portfolio to the total return of its chosen benchmark over the same period.
The formula is expressed as:
Where:
- (\text{Portfolio Return}) is the total percentage return generated by the investment portfolio.
- (\text{Benchmark Return}) is the total percentage return of the chosen benchmark index over the identical period.
For example, if a portfolio generates a 12% return and its benchmark, such as the S&P 500, returns 10% over the same period, the relative return is:
A positive relative return, as in this example, indicates outperformance, while a negative relative return signifies underperformance compared to the benchmark. This calculation relies on accurate total return figures for both the investment and the benchmark, incorporating both capital appreciation and any income generated, such as dividends or interest.
Interpreting the Relative Returns
Interpreting relative returns is fundamental to assessing the true value added by an investment manager or a particular investment vehicle. A positive relative return signifies that the investment has outperformed its benchmark, suggesting that the manager's decisions (e.g., stock selection, sector allocation, or timing) added value beyond what a passive investment in the benchmark would have achieved. Conversely, a negative relative return indicates underperformance, meaning the investment lagged the market or its comparative standard.
The magnitude of the relative return is also important. A consistently small positive relative return might suggest a manager is largely tracking the benchmark with slight advantages, while a large positive relative return indicates significant outperformance. It is also critical to consider the risk-adjusted return when interpreting relative returns, as achieving higher returns by taking on excessive risk may not be a desirable outcome.
Hypothetical Example
Consider an investor, Sarah, who has a diversified mutual fund that invests primarily in large-cap U.S. stocks. She has chosen the S&P 500 as her fund's benchmark. Over the past year, Sarah's mutual fund achieved a total return of 15%. During the same period, the S&P 500 index generated a total return of 12%.
To calculate the relative return of Sarah's mutual fund:
- Portfolio Return: 15%
- Benchmark Return (S&P 500): 12%
Applying the formula:
Relative Return = Portfolio Return - Benchmark Return
Relative Return = 15% - 12% = 3%
In this scenario, Sarah's mutual fund had a relative return of +3%. This indicates that her fund outperformed the S&P 500 by 3 percentage points over the last year. This positive relative return suggests that the fund manager's investment decisions added value beyond simply tracking the broad market, which aligns with the goal of diversification to enhance returns or manage risk.
Practical Applications
Relative returns are extensively used across the financial industry by various stakeholders. For portfolio managers and mutual fund companies, measuring performance against a benchmark is standard practice. They often aim to generate positive relative returns to justify their fees and demonstrate their expertise. Investment advisors use relative returns to help clients understand how their portfolios are performing compared to broader market trends or specific investment goals.
Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), also have rules regarding how investment performance, including relative returns, can be advertised to the public. For instance, investment advisers must present net performance alongside gross performance with equal prominence, and typically over prescribed periods (e.g., one, five, and ten years), to ensure transparency and facilitate comparison.5,4 This emphasis on contextualized performance prevents misleading claims and helps investors make informed decisions. Furthermore, institutional investors, such as pension funds and endowments, often set specific relative return targets for their external money managers, using these metrics to guide manager selection and capital markets allocation decisions.
Limitations and Criticisms
While relative returns offer valuable insights into investment performance, they also have limitations. One primary criticism is that an investment can achieve a "good" relative return even if its absolute return is negative, as long as it outperforms a more severely declining benchmark. For example, if the market drops by 20% and a fund drops by 15%, it has a positive relative return of 5%, despite incurring a substantial loss for the investor. This can sometimes lead to a disconnect between a manager's reported success and an investor's actual loss of capital.
Another drawback is the potential for "benchmark hugging," where managers may prioritize tracking the benchmark closely to avoid significant underperformance rather than pursuing genuinely differentiated strategies that could yield higher absolute returns. Critics argue that this can stifle innovation and lead to portfolios that are merely slight variations of the index, potentially limiting true diversification benefits. Moreover, the act of benchmarking itself has come under scrutiny, with some arguing that it can introduce biases or encourage a focus on lagging indicators rather than forward-looking strategies.3,2 Investors who solely focus on relative returns might overlook essential aspects like the level of market volatility or the suitability of the benchmark itself.
Relative Returns vs. Absolute Returns
Relative returns and absolute returns are distinct but complementary ways to evaluate investment performance. Absolute returns measure the total percentage gain or loss of an investment over a specific period, independent of any external comparison. It simply tells an investor how much their investment has increased or decreased in value. For example, if an investment grew from $10,000 to $11,000, its absolute return is 10%.
In contrast, relative returns compare this absolute performance against a chosen benchmark, such as a market index or a peer group. The key difference lies in the context provided: absolute returns tell you what your investment did, while relative returns tell you how well it did compared to something else. Fund managers focused on absolute returns aim to generate positive returns regardless of market conditions, often employing alternative strategies. Managers focused on relative returns, typical in traditional mutual funds and Exchange-Traded Fund (ETF) management, seek to beat a specific index, even if the overall market is down.1, Understanding both metrics is crucial for a comprehensive view of an investment's success.
FAQs
What does it mean if my portfolio has a positive relative return?
A positive relative return means your portfolio performed better than its chosen benchmark over a specific period. For example, if your portfolio gained 8% while its benchmark gained 5%, you have a positive relative return of 3%. This indicates outperformance.
Can an investment have a negative absolute return but a positive relative return?
Yes, this is possible. If your portfolio loses less than its benchmark during a market downturn, you will have a negative absolute return (you lost money) but a positive relative return (you lost less than the benchmark). For example, if your portfolio dropped by 10% and the benchmark dropped by 15%, your absolute return is -10%, but your relative return is +5%.
Why is relative return important for investors?
Relative return is important because it provides context for your investment's performance. It helps you assess if your investment strategy or manager is adding value compared to the broader market or alternative investment opportunities. It's particularly useful when evaluating actively managed funds, as their goal is typically to outperform a benchmark, rather than simply achieve a positive return.
What is a common benchmark used for relative returns?
One of the most common benchmarks for U.S. equity portfolios is the S&P 500 index, which tracks the performance of 500 large U.S. companies. Other common benchmarks include the Dow Jones Industrial Average, Nasdaq Composite, or various bond indexes for fixed-income portfolios. The appropriate benchmark depends on the investment's objectives and its underlying investment vehicle.
How do passive management strategies relate to relative returns?
Passive management strategies, such as investing in index funds or ETFs, aim to replicate the performance of a specific market index. Therefore, their goal is to achieve a relative return of approximately zero (or very close to it, after accounting for fees and tracking error). They are not designed to outperform the benchmark, but rather to match its performance as closely as possible.