Absolute return is the return that an asset or portfolio achieves over a specified period. This return can be positive or negative. It is expressed as a percentage, and it considers the appreciation or depreciation of the asset.
Alfred Winslow Jones is known as the first person who formed the very first absolute return fund in New York in 1949. Nowadays, this way of fund investing is considered one of the fastest-growing investment products in the world and it is generally termed as a hedge fund.
What is Absolute Return?
Definition: It is defined as the funds that your investment has earned over a specified period. It is also known as total return, which measures the gain or loss experienced by the asset or portfolio.
The fund managers who use absolute return as a measure to check the performance of the investment usually aim to develop a portfolio that can be diversified across asset classes, geography, and economic cycles. Here, the managers give special attention to the correlation between the different components of the portfolio.
The managers use the different employing techniques in the absolute return fund that can help them to earn positive returns. These techniques are different from that of the traditional mutual fund. Here, the concepts of futures, options, derivates, arbitrage, leverage are used. The time horizon here is generally short. Many fund managers avoid long-lasting market trends. Instead of it, they look to trade the short-term price swings. However, it is different from the relative return.
Relative Return vs. Absolute Return
Relative return is the difference between the absolute return and the performance of the market, which is gauged by a benchmark. The fund managers who measure the performance of the funds by relative returns usually depend on the proven market trends to achieve their desired return. The managers here perform a global and detailed economic analysis on companies which helps them to determine the direction of a particular stock.
On the other hand, absolute returns represent the return which an asset or portfolio has achieved over a certain period. It does not provide much information to the investors. An investor has to see the relative return to determine how their investment return is compared to other similar investments. Once they get a comparable benchmark, they can decide whether their investments are doing good or poor. Then, they can decide on that basis.
Example of Absolute & Relative Returns
Let’s understand the difference with an example in the context of a market cycle, which includes the bull market and bear market. A bull market is a rising market, and the conditions are generally favorable, while a bear market is the opposite of it. A bear market is a market where the stock values are declining and the economy is receding.
In a bull market, a gain of 2% is seen as a horrible return, while in the bear market, the loss of 20% and preserving the capital is considered a triumph for the investors. In the bear market, getting a 2% return is not bad. Here, the value of returns changes with the change in the market situations.
Therefore, in this example, 2% is the absolute return. Because of the relative return, the 2% is considered bad in the bull market and good in the bear market.
The Formula for Calculating Absolute Returns
The formula for calculating it is as follows:
Absolute return = ((Current value- Purchase Value) / Purchase Value) x 100
Suppose an invested INR 5,000,000 in the real estate. After two years, the property price has increased, and now the saleable price of the property is INR 6,000,000. Now, if the investor wants to calculate absolute return on his investment, then the calculation will be as follows:
Absolute Return= ((6,000,000 – 5,000,000) / 5,000,000) x 100 = 20%
Therefore, the investor made an absolute return of 20% on the property purchased two years back.
Features of Absolute Return Strategy
1. Positive returns
The main focus or aim of the absolute returns is to generate positive returns at all costs. It does not consider the ongoing conditions of the market, which means whether it is rising or falling. The portfolios here are developed with the primary aim of achieving positive returns.
2. Diversification of Portfolio
As mentioned above, the primary aim of the portfolio is to generate positive returns at all costs/ Therefore, in this case, the diversified portfolio is made. Making a diversified portfolio is to spread the risk with different investment options that can generate returns in different ways for different periods.
3. Less Volatility
The volatility of the absolute return funds is less. It is so because the funds aim to generate positive returns, and they are diversified in their structure. Here, the overall risk of investment is spread across different assets of the portfolio.
4. Adjustable to equity market movements
The absolute return funds are actively adjustable to the movements of the equity market. This means that when the market is on a decline, it shares a negative correlation with the absolute return funds and vice-versa.
5. No benchmarks needed
In the case of absolute returns, the funds are independent of the benchmarks or market indexes. This means that it is considered in absolute terms and not relative to. In other words, the returns here are not compared with the returns earned by an investor on similar investments. This happens in relative returns. But absolute returns are completely free from it.
Absolute Return Vs. Annualized Return
- Annualized return is the average return which an investment earned over some time. At the same time, the absolute returns are the total return that measures the performance of investment regardless of any period.
- Annualized returns are expressed in percentage only, but an absolute return can be expressed in both INR and percentage.
- Calculating absolute returns is easier as compared to calculating annualized return on investment.
- It is challenging to compare the absolute return from 2 investments, but with the annualized return, an investor can compare the return from 2 investments. It is so because, in the case, there is an unknown period which makes it challenging. But, in the case of an annualized return, it is easy to compare because of the availability of the period. The investor here can choose an investment with a high annualized return.
On the concluding note, it is clear that absolute returns are the percentage amount that an asset or investment rises or declines in value in a particular period.
Now, after understanding the whole concept what will your definition of absolute return? Share with us in the comment section below.