Relative return
Encyclopedia
Relative return is a measure of the return of an investment portfolio relative to a theoretical passive reference portfolio or benchmark.
In active portfolio management, the aim is to maximize the relative return (often subject to a risk constraint). In passive portfolio management, the aim is to obtain a relative return as close to zero as possible, thereby reproducing the return of the theoretical reference portfolio. When the relative return is positive, the portfolio is said to outperform the benchmark. Conversely, when the relative return is negative, the portfolio is said to underperform the benchmark.
Within passive portfolio management, the absolute value of the relative return is often called the tracking error
, which is confusing since the tracking error
is more generally defined as the standard deviation of the relative return. Index fund
s are the financial products that use passively managed portfolios.
The relative return measure is a useful measure to evaluate the skill of the portfolio manager: if the relative return is positive, then the portfolio manager has skill. However, the relative return measure by itself is not sufficient to quantify how much skill a portfolio manager has, since the measure does not take into account the amount of risk that the portfolio manager has taken. In order to compare two outperforming portfolio managers, one should therefore consider not only the relative return, but also the risk taken by each portfolio manager.
Juxtaposed with the relative return measure is the absolute return
measure, which is used to describe the return of the investment portfolio itself. In recent years, so-called absolute return strategies, that aim to always produce a positive absolute return regardless of the directions of financial market, have become popular. Contrary to popular opinion, it is not true that the relative return cannot be measured in a meaningful sense for absolute return strategies. After all, the neutral position of these portfolios is to be fully invested in cash without any other long or short positions. Thus, the risk-free rate is an appropriate benchmark to use for measuring the relative return of absolute return strategies.
In active portfolio management, the aim is to maximize the relative return (often subject to a risk constraint). In passive portfolio management, the aim is to obtain a relative return as close to zero as possible, thereby reproducing the return of the theoretical reference portfolio. When the relative return is positive, the portfolio is said to outperform the benchmark. Conversely, when the relative return is negative, the portfolio is said to underperform the benchmark.
Within passive portfolio management, the absolute value of the relative return is often called the tracking error
Tracking error
In finance, tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. The most common measure is the root-mean-square of the difference between the portfolio and index returns....
, which is confusing since the tracking error
Tracking error
In finance, tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. The most common measure is the root-mean-square of the difference between the portfolio and index returns....
is more generally defined as the standard deviation of the relative return. Index fund
Index fund
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
s are the financial products that use passively managed portfolios.
The relative return measure is a useful measure to evaluate the skill of the portfolio manager: if the relative return is positive, then the portfolio manager has skill. However, the relative return measure by itself is not sufficient to quantify how much skill a portfolio manager has, since the measure does not take into account the amount of risk that the portfolio manager has taken. In order to compare two outperforming portfolio managers, one should therefore consider not only the relative return, but also the risk taken by each portfolio manager.
Juxtaposed with the relative return measure is the absolute return
Absolute return
The absolute return or simply return is a measure of the gain or loss on an investment portfolio expressed as a percentage of invested capital. The adjective absolute is used to stress the distinction with the relative return measures often used by long-only equity funds, i.e...
measure, which is used to describe the return of the investment portfolio itself. In recent years, so-called absolute return strategies, that aim to always produce a positive absolute return regardless of the directions of financial market, have become popular. Contrary to popular opinion, it is not true that the relative return cannot be measured in a meaningful sense for absolute return strategies. After all, the neutral position of these portfolios is to be fully invested in cash without any other long or short positions. Thus, the risk-free rate is an appropriate benchmark to use for measuring the relative return of absolute return strategies.
See also
- Index fundIndex fundAn index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.-Tracking:Tracking can be achieved by trying to hold all of the...
- Enhanced indexingEnhanced IndexingIn finance, enhanced indexing is a catch-all term that describes strategies employed to outperform traditional indexing. Enhanced indexing attempts to generate modest excess returns compared to index funds and other passive management techniques.-Features:...
- Return