Before getting into investment, you should understand the difference between absolute return and relative return. In this article, we will be discussing the meaning of absolute return, relative return and the difference between these two.
Absolute return means the return that an asset achieved over a certain period of time. It’s expressed as a percentage of the initial investments to know the return that an asset has achieved for the period. Return can be positive or negative. In case of a mutual fund, it measures the appreciation or depreciation of the fund over a given period of time in percentage.
If you find a mutual fund has achieved 20% return for the year, then it’s the mutual fund’s absolute return. Likewise, if you find nifty or sensex or any other index has achieved a positive return of 17% for the year, then it’s that index’s absolute return.
This means if you have calculated absolute return for an asset or portfolio, then you will know how it has performed over a period of time.
Absolute return = (Market value of the portfolio – Invested value ) / Invested Value
If the current market value of the investment is Rs 100000 and the invested amount is Rs 80000, then absolute return is 25% (i.e. (100000-80000)/80000)
However, if you wanted to know how your fund manager or portfolio has performed in comparison to others, then you should compare it with the rest of the market’s performance. In this case absolute return will not help you as it does not say much in terms of the asset’s / portfolio’s performance. Here you should be interested to know what the relative return is.
Generally mutual fund’s performance is compared relative to a benchmark. For instance if you want to compare a mutual fund performance relative to the return of Sensex or Nifty, then you need to find out the relative return of the mutual fund.
Now the question is how you will know whether your fund has performed better than its peers or fund or market as a whole. To do that, you need to compare with a benchmark or overall market performance to know how it’s performed in comparison to the rest of the market. This approach of comparison is known as the relative return approach to fund investing.
In the market, if a fund outperforms its benchmark, it’s considered as a success. If the fund under-performed its benchmark, it’s considered a failure.
Relative return is the difference between the absolute return and market performance. Relative return is also referred to as alpha. It tells you how your fund has performed compared to how it should have performed.
The difference between absolute and relative return is that in case of absolute return, you are just concerned with the simple return of the portfolio without comparing it to any other benchmark or index. Therefore, you need to look at relative return to know how investment has performed compared to other similar investments.
It’s very popular among market participants as by comparing both they can know whether the investment has done well or poorly.
Formula to calculate relative return = absolute return – benchmark index return
You can take any market index or benchmark to compare your asset’s or portfolio’s return with it to get the alpha you have achieved. In this way, one can easily know which mutual fund or portfolio has better return in comparison to index.
For example, if the Sensex has gone up by 17% for the year and your portfolio return is up by 22% for the year, then the relative return of the portfolio is 5% (i.e. 22%-17%). In this case the absolute return of your portfolio is 22%.
If you have invested in a few banking sector stocks which have given you a negative return of 20%, then to know your performance, you need to compare it with the banking index. If the banking index has given a negative 26% return, then in reality you outperformed the banking index even though you have a negative return.
Therefore, investors or fund managers always track their performance against a comparable index for the same time period.