Meaning and definition of relative return
Relative return refers to the return achieved by an asset over a specific time period contrasted to a benchmark. The relative return is computed as the difference between the absolute return reached by the asset and the return reached by the benchmark.
As explained by Investopedia, relative returns are used generally while reviewing the performance of a mutual fund manager. Since mutual fund holders are charged management fees, they expect a manager to reach higher returns as contrasted with the benchmark index.
Example of relative return
Let us presume that a fund held by you achieves a complete return of 12% in the past year whereas the benchmark index gives a return of 15%. The fund is then believed to have achieved a relative return of -3% for the specific year.
Calculating relative return
Relative return reveals how the return from an asset is compared with a benchmark. The benchmark can be anything from the performance of a similar asset to the performance of an entire stock index. The choice of benchmark depends upon the investor. Relative return is useful as it provides the investor with an idea about the performance of one asset compared to that of another.
The main steps involved in the estimation of relative return include:
1. Estimate the absolute return. The absolute return refers to the return showed by an investment for a specific period. For instance, the portfolio of Investor A shows a gain of 15% in the previous year.
2. Calculate the benchmark return. The return can be calculated for any benchmark an investor wants to contrast the investment with. The return is generally found while researching an index or computing the return on similar investment which is the benchmark. In the aforementioned example, the benchmark is a stock index. The index for all of Investor A’s stocks in the portfolio feature an overall return of 8% for the year.
3. Deduct the benchmarked return from the absolute return thus reaching the relative return. In the example above, 15% - 8% gives a relative return of 7%.