Difference Between Absolute and Relative Returns

Knowing the difference between absolute and relative returns is fundamental to understanding how the hedge fund industry developed and the key benefit to investing in a hedge fund.  In the following video, I explain the difference between absolute and relative returns and why this distinction is important.

Video Transcript/SummaryThe strategies and tips provided within this video module include:

  1. Before hedge funds, investors often suffered heavy losses by being only long on stocks during a market downswing. 
  2. Hedge funds allowed investors to insulate themselves to some degree from market shifts by hedging their long bets with shorts.
  3. Hedge funds seek absolute returns instead of relative returns.  
  4. Absolute returns means that the hedge fund aims for an absolute return of x% every year irrespective of what happens in the stock market.
  5. Relative return managers peg their performance to other fund managers or indices instead of an absolute return.  
  6. When you hear people talk about absolute return understand that they are shooting for a return no matter what their competitors or the stock market is doing. 
Transcript of Difference Between Absolute and Relative Returns

Hello, this is Richard Wilson and today I’m going to explain to you the difference between Absolute Returns and Relative Returns. It’s a pretty fundamental concept to understanding how hedge funds work and how they came about. So I think it’s really important to understand this if you’re taking the CHP designation or just working on the hedge fund industry in general.

So to start with, the hedge fund industry started because people figured out that when the stock market goes down, they don’t want to be losing money by being long on stocks, by buying stock. They want to be able to short stocks, and use both long stocks and shorting stocks within the same portfolio. It’s kind of hedging your risk with shorting some stocks, and the portfolio is kind of where the term hedge fund came about from.

So having an absolute returns versus relative returns is really at the core of what the whole hedge fund industry is all about. Absolute returns means that for your investors and your hedge fund, if you’re an absolute return hedge fund, you’re trying to return let’s say 7% or more every single year. It doesn’t matter what the economy does, what the stock market does, you are trying to get that 7% return and you’re trying to do that by shorting stocks you think are weak or are going to go down in value or down in price. You can go in long on stocks that you believe, or buying stocks that you believe are going to do relatively well compared to the greater marketplace.

This way if a market goes down, you make money on your shorts. If the market goes up, you make money on the long that you’ve made, and you’re trying to get that 7% return no matter what happens in the marketplace. Relative return managers are really trying to beat the market. They might pin themselves against the S&P 500 and more likely against other hedge fund managers that run their type of strategy like long or short equity or global macro. But with a relative strategy, if the market goes down 20% and you only go down 10% then that’s the reason to celebrate because you’re trying to beat the market and you just lost half as much.

If the market, it goes up to 7% and you go up 15%, again, that’s another reason to celebrate if you’re a relative return manager in most cases, then that’s what you’re trying to do. Some of the issues they have come up lately have been whether there are that many absolute return managers out there. During the two recent financial crises, when the economy went down, the stock market went down drastically. The truth is even “absolute return managers” lost some money. Almost all of them did. Some of them are very proud to have only lost 4%, the market might have went down 15% or 25%. But the truth is how absolute return are these mangers if almost nobody had an absolute steady return.

So it’s really a degree. You can think about it as a relative sliding scale of how much they’re focused on relative returns versus absolute returns in the hedge fund. But for the certified hedge fund professional designation, if you’re working on the hedge fund industry, when you hear people talking about absolute returns, you have to know they’re shooting for a return no matter what the stock market is doing, where relative returns are based on how someone was doing relatively compared to the broader stock market.

So thank you for joining me for this video. I hope this helps explain absolute versus relative returns and I’ll speak with you again soon.

I hope that after watching this video you have a better understanding of the difference between absolute and relative returns and why it an important concept for hedge funds.      

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About Richard Wilson