Relative Return - Explained
What is Relative Return?
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Table of ContentsWhat is Relative Return?How Does Relative Return Work?How Relative Return is CalculatedIllustration of Calculation of Relative ReturnRelative Return vs. Absolute Return
What is Relative Return?
Relative return is a measure used in investing that estimates the return on an asset or any other investment portfolio over a specific period of time relative to a theoretical benchmark. The relative return is calculated as the difference between the absolute return achieved by the asset or investment portfolio and the return achieved by the benchmark. Mathematically, relative return can be expressed as Relative Return = Absolute Return of Asset - Absolute Return of Benchmark, where, Absolute Return = (Current Value of Investment - Original Value of Investment) / Original Value of Investment. Thus, a positive value of the relative return signifies the outperformance of the asset or investment portfolio over the benchmark. Conversely, a negative value of the relative return signifies an underperformance of the asset or investment portfolio compared to the benchmark.
How Does Relative Return Work?
Relative return is an effective tool for evaluating the performance of both actively managed as well as passively managed funds. While in active portfolio management, the primary goal is to maximize the relative return, in passive portfolio management, the objective is to achieve a relative return that is as close to zero as possible. Thus, relative return can be used to accurately gauge the performance of a portfolio manager and is most often used to review the performance of mutual fund managers. Relative return is also frequently used as a tool to analyze the performance of various investments relative to accepted benchmarks.
How Relative Return is Calculated
Calculating relative return is a pretty straightforward, albeit laborious process. It is derived by subtracting the return of a benchmark from the return on the investment at hand. As such, the benchmark will have to be ascertained first. This benchmark can refer to a similar asset, an entire stock index or anything in between choosing an appropriate benchmark is at the sole discretion of the investor. The following steps are to be followed in order to calculate the relative return on an investment:
- Determine Absolute Return: The absolute return is the return generated by the particular investment over a specific period in time.
- Determine Benchmark Return: After choosing an appropriate benchmark, the investor can compute the benchmark return either by calculating the return on similar (benchmarked) investments or by perusing the entre stock index.
- Subtract the benchmark return from the absolute return: This subtraction will yield the relative return.
Illustration of Calculation of Relative Return
The procedure of calculation of relative return can be better illustrated with the help of a simple example. Suppose, mutual fund M1 returns 12% over a specific period of time. Such a return may seem lucrative or even rather high, especially when considered on its own. However, given that the benchmark index MB is 20% over the same period of time, the relative return on M1 would be (12% - 20%) = - 8%. This negative value of the relative return itself can steer investment decisions away from fund M1. Now, let us consider another example where an original investment of $1,000 in investment portfolio P1 grows to $1,500 in a period of three years. Supposing that the benchmark portfolio PB worth $1,000 grew to $1,200 during the same period, we can make the following deductions. Absolute Return of P1 = ($1,500 - $1,000) / $1,000 = 50% Absolute Return of PB = ($1,200 - $1,000) / $1,000 = 20% Relative Return = 50% - 20% = 30%. Thus, the relative return of investment portfolio P1 over a period of three years is 30%. This can also be stated on an annual basis by simply dividing the relative return by the number of years. In this example, the relative return would be 30% / 3 years = 10% per year. There is no doubt that investment decisions would favor portfolio P1, albeit subject to a risk constraint.
Relative Return vs. Absolute Return
There are several differences between relative and absolute return. Some of these differences are listed below.
- While it is possible to determine absolute return values quite conveniently by perusing stock and mutual fund documents and performing simple calculations, the calculation of relative return is a much more laborious process.
- The process of calculating relative return is flexible in that it allows the investor to choose his/her own benchmark. On the other hand, the absolute return calculation process completely ignores the fact that investors can have choices.
- Relative return offers investors much deeper insight into the performance of any investment compared to absolute return. Unlike absolute return, relative return offers a comparison against a benchmark. Moreover, in cases where the rate of inflation is used as the benchmark, the relative return provides the investor with an insight into the real-time growth of money.