Compare & Calculate Absolute Return vs. Relative Return

“The wise man is he who knows the relative value of things."

– William J. Bernstein

Evaluating investment performance comes in many forms, but most would agree that absolute and relative returns are likely two of the most crucial metrics. In this document, you'll learn how to measure each method to better understand its unique impact on investment performance. Ultimately, recognizing the differences between absolute and relative returns can help you create an overall strategy to build an investment portfolio that aligns with your goals.

With relatively simple formulas and definitions, you'll be more confident in making informed investment decisions by the end of this article.

Introduction to Returns & Investment Performance

Returns are typically top of mind for most, if not all, investors. There are conventionally two components of a return:

1. Income generated—typically through dividends or interest payments

2. The capital gain or loss—calculated by the change in value from the purchase price

The goal is to buy securities that grow in value over the long run while earning income along the way. A positive return is achieved if the combination of income earned and the appreciation or depreciation is greater than your original investment, which is known as the total return. 

Why are returns important for investors?

Investors hoping to build their wealth for retirement tend to have different risk profiles, preferences, goals, or personal circumstances compared to those aiming to supplement their income once they no longer have a regular salary.

As a result, the investment strategies best suited to them are quite different—a young investor can typically invest more aggressively given their career, future earning power ahead of them, and overall long-term time horizon.

On the other hand, a retiree presumably has more immediate needs and can't handle a potential loss nearly as well since they typically lack the means to rebuild their savings and investment portfolio.

How do returns work and impact investment decisions?

As a general rule of thumb, securities with the highest expected returns carry the most risk. Investors who focus on beating a benchmark with strong returns must be comfortable with the associated hazards.

Another aspect to consider, as mentioned previously, is time horizon—day-to-day volatility, more commonly known as price fluctuations, isn't as difficult to weather if you intend to build up your portfolio's value over many years. However, if you require funds in the near term, taking on unnecessary risk may be unwise—waiting for your declining portfolio to recover might not fit your schedule.

Understanding Absolute Return

If you invested $100 in a market index fund that grew to $120, your absolute return would be 20%. In sum, an absolute return measures the raw gain or loss without comparing it to any benchmark or other portion of the wider market. Remember—the annual percentage gain is also impacted by the length of time that you own the investment.

How is absolute return calculated?

Sometimes demonstrated in nominal dollar terms, absolute returns expressed as a percentage are calculated as:

([ending value] / [starting value]) - 1 = absolute return rate

For instance, let's say you bought a real estate property for $500,000, and it appreciated to $600,000 over a span of five years:

($600,000 / $500,000) - 1 = 0.20 = 20%

Calculating the annualized rate of return is more complex since you need to account for the compounding of income. As a ballpark, you could take the total percentage return and divide it by the number of years.

20% divided by 4 years = 5% annualized return (estimate)

But how did your cousin's property perform in a more desirable neighbourhood? Did the S&P 500 deliver a higher return to investors over that same period? In terms of absolute returns, neither question matters—all it measures is the performance of an isolated investment. 

Absolute returns ultimately determine how much your investment portfolio will grow over time. A “target” return is often used in financial planning to ensure that you will achieve your long-term goals, such as having enough money to retire in comfort. Absolute returns do not, however, provide any context in terms of how well your portfolio has done relative to other investments or strategies available to you.

Understanding Relative Return

Relative returns use a point of comparison to contextualize investment performance to see if it's beating or lagging a benchmark, such as a market index or an entirely different type of asset. It can also be used to evaluate the success or failure of your strategy relative to peers, such as other strategies with a similar risk profile. This additional information can help investors assess whether or not their capital is working as effectively as it could, or if other managers or products might be a better fit for their needs.

How is absolute return calculated?

Again, the math is surprisingly simple here. Once you've selected your benchmark or market index to compare your investment return, all you need to do is find the difference:

[investment return] - [benchmark return] = relative return

To get the most out of calculating relative returns, we'd recommend using several date ranges. We've drafted a hypothetical scenario below to illustrate why:

After year one, you are likely pleased with how Fund ABC has performed in comparison to the benchmark, but after three years, you might feel a sense of disappointment over the -3% relative returns.

Zooming out can help add perspective. Five years prior, the market went through a severe crash—although in absolute terms investors only made a modest return of 2%, the portfolio managers did a fantastic job of protecting client capital in such a deep bear market and delivered a relative return of 8%. Thanks to a disciplined approach and diligent risk management, this one year of exceptional performance helped deliver 3% per year of outperformance since inception.

In plainer terms, Fund ABC has outperformed its benchmark by 3% in annualized returns since it was first founded, regardless of short-term fluctuations.

What benchmarks are used for relative return?

You could use anything, even something unexpected like The Economist's Big Mac Index, which measures relative purchasing power between different nations, but relevance is key. A strong benchmark is often highly correlated to the asset class or portfolio being compared. The S&P/TSX and S&P 500 indices are popular options for equity investors, while fixed income strategies are commonly compared to the FTSE Universe Bond Index.

Often, managers may blend various options to create a portfolio benchmark that is even more closely aligned with the overall makeup of their assets under management. 

Key differences between absolute return and relative return

When calculating the return on investment (ROI), the first question you should ask yourself is what you are trying to learn—absolute return refers to raw performance, whereas relative return measures how portfolios stack up compared to a broader market or peer group. There is no right or wrong answer. Frankly, we find that it’s often best to combine the two, understand the details, and see the bigger picture.

In what situations does one outperform the other?

Certain investment strategies seek to deliver a higher degree of consistency in generating absolute returns or, in other words, fewer fluctuations in return from year to year. Such approaches hope to provide investors with a “smoother ride” through a complete market cycle. These methods may underperform market indices in strong years while doing a better job of protecting capital in challenging periods.

Keep in mind that it is very difficult to produce positive returns in years where stock markets have negative returns unless you focus on very conservative investments such as guaranteed investment certificates.

In comparison, relative return strategies look for ways to beat their respective benchmarks by adding value through active management. They typically construct portfolios that look quite similar to the index or benchmark that they are comparing themselves to. Such approaches often involve modest deviations in the amount of money invested in certain industry sectors or the securities that they choose to invest in. Managers utilize various strategies to attempt to beat the index benchmark, including fundamental, quantitative, and technical analysis.

The investment industry does not have a good track record in being able to consistently outperform certain market indices, which has led to the popularity of exchange-traded funds. However, investors must evaluate whether a given market index is an appropriate benchmark to measure against—some indices may be too volatile for an investor’s risk tolerance, so finding the right point of comparison is crucial. This becomes doubly true in the case of active managers using customized investment strategies to better serve their clients—a portfolio built to minimize risk and generate higher levels of income wouldn’t be a fair comparison to the S&P 500, but a blended benchmark might be fitting.

There's no reason one might be better than the other. What matters is which is more suitable for your needs.

What examples illustrate the effectiveness of absolute return strategies?

Other than shorter-term securities such as GICs, it’s nearly impossible to find an investment that consistently delivers positive annual returns.

That said, portfolios designed to deliver more predictable returns from year to year may often include an allocation to private securities, which are priced less frequently and, in effect, avoid short-term swings in investor sentiment—two factors that contribute to volatility. Other strategies focus on stocks that have historically demonstrated less intense fluctuations.

Private Credit

Unlike bonds, the value of private credit is not impacted by changes in the level of interest rates; rather, the amount of income earned on such lending strategies tends to rise and fall with rates. The absence of traditional lenders typically results in higher lending rates. The combination produces an asset that is likely to generate higher returns with less volatility than government or corporate bonds.

Private real estate & infrastructure

Investments in global real estate and infrastructure often generate predictable income that will rise gradually with inflation due to the price escalators or rent hikes that are built into long-term contracts. Much like private credit, the value of such securities does not change much on a day-to-day basis.

Different investors, different solutions

A dividend growth philosophy has historically outperformed market indices over the long run, while exhibiting less volatility as well as enhanced downside protection in down markets.

Some hedge funds market themselves as “absolute return funds” with a goal to produce positive returns in all years using derivatives and other complex investment techniques. Their track record, however, is patchy at best compared to the historical reliability of dividend growth.

While “alternative approaches” have delivered impressive long-term returns with less risk, they also tend to underperform in years when the public bond and stock markets are surging. Keep in mind that private credit, real estate, infrastructure, and dividend growth stocks tend to hold up much better in challenging times. An investor must decide for themselves whether they like such a trade-off.

What examples highlight the significance of relative return strategies?

Recent experience in North American fixed income markets makes for a good case study for relative returns. Significant interest rate hikes across North America in 2022 and 2023 took their toll on the bond market, leading to one of the worst environments in over two centuries.

Managers who were focused on long-term trends—deteriorating government finances and the eventual normalization of interest rates—fared much better as they had previously rotated into different fixed income securities. While the FTSE Canadian Bond Universe Total Return Index dropped 5.8% over the two-year period (as at December 31st, 2023), Bellwether’s Fixed Income Composite delivered a 3.9% gain over the same period, resulting in an additional 9.7% value for our clients in relative terms.

The value generated comes in the form of protecting, and in this case, growing client capital. Had our strategy sought to mimic the index rather than use it as a measurement tool, it would have been an entirely different story.

What are the risks associated with focusing on absolute return vs. relative return?

Like any investment, you can manage risk, but it's rare to completely avoid it.

If an investor is using absolute returns to gauge how much value their manager is adding, they should always be conscious of the time period being assessed. Most investment strategies will experience years in which they have a negative return, but it would be brash to immediately call the strategy a failure based on a small sample size. Below, we illustrate how the probability of loss declines over the years, serving as a useful reminder that time in the market is a vital component of investing.

The good news is that the likelihood of loss diminishes greatly over longer time periods. Another challenge of evaluating portfolios on an absolute return basis is that you won’t know how you are doing compared to other strategies or managers.

However, investors who exclusively concentrate on relative return strategies may also encounter challenges. Managers who are preoccupied with "beating the index" are typically less concerned about volatility levels or capital preservation in poor markets. In turn, they may be exposing their clients to undue risk. To outperform an index, you must be willing to embrace the volatility or risk that comes with the territory.

In evaluating both absolute and relative returns, it is imperative that you compare strategies and benchmarks with comparable risk. A more growth-oriented strategy should deliver higher absolute returns in the long run, but is also likely to mean a higher level of fluctuations in value over the short term. If a GIC earns 4% over the last year and your investment portfolio loses 2%, that does not mean that the GIC is a better strategy. They are not an “apples-to-apples” comparison.

When Investors Should Use Absolute Return vs. Relative Return

A balanced approach that uses both metrics to some degree can lend investors a wider perspective. Similar to diversifying across asset classes, geographic locations, and public and private investments, it's wise to do so with key performance metrics too, as they can inform portfolio decisions.

Therefore, investors should not view the debate between "absolute return" and "relative return" as a competition, but rather, they should recognize the unique contributions each can make to their overall strategy. Ideally, an investor would benefit from an all-weather portfolio that can perform across a variety of different market conditions. 

Absolute and Relative Returns for Your Portfolio & Assets

Assessing investments doesn't need to be intimidating if you're familiar with how to use the resources at your disposal:

• Absolute return refers to the total gain or loss from an investment without a point of comparison. It's useful for evaluating the overall consistency and performance of the investment vehicle or strategy.

• Relative return adds additional context by providing a benchmark to weigh it against. It can help confirm whether or not your money could be better served by a different investment vehicle or strategy.

They're both valuable, but when used together, investors can make more confident decisions to structure a portfolio that meets their goals and expectations—both today and into the future.