The Hindu Business Line : Absolute truths on relative returns

Jayesh is puzzled by his mutual fund update. The markets underwent a major downward correction from the time he invested. Yet the fund he invested in was at the top of the rankings. Can a fund with a negative performance be at the top? Puzzled just as Jayesh is? Let’s clear the air on absolute versus relative returns. A fund may claim to be on top of fund rankings and the fund manager may claim good performance even when the fund registers an absolute decline in Net Asset Value (NAV) and records losses. Similarly, even if a fund records what may be a good absolute return, it can still be classified a relative underperformer.

Absolute return

Absolute return looks at the appreciation or depreciation (expressed as a percentage) that a fund achieves over a given period of time. You may expect a 20 per cent return from your equity fund over a six-month period but the actual return is only 18 per cent. So, should you be happy or not?

This will depend on how the general market has performed, measured by the benchmark index used by the fund, which could be the BSE Sensex, Nifty or any other benchmark. Let’s say you invested in fund ‘A’ at an NAV of Rs 10 on January 1, 2006; it has appreciated to Rs 15 by December. The absolute return is 50 per cent.

Relative return is important

Relative return is the difference between the absolute return achieved by the asset and the return achieved by the benchmark. For example, if the fund you are holding achieves an absolute return of 12 per cent while the benchmark index managed 15 per cent, then the fund has achieved a relative return of a negative 3 per cent. A fund that falls less than the benchmark in a falling market is considered to have done well as it manages to contain losses for the investor. Similarly, a fund that beats the benchmark has managed to better the typical market portfolio. The stock market moves in cycles, known as secular bull and bear markets (secular here means a long period). In secular bull markets, you should focus on investments that offer positive relative returns. Why should you look at it relatively?

Relative return is a way to measure the performance of actively managed funds, which should get a return greater than that of the market.

After all, you can always buy an index fund that has a low Management Expense Ratio and will guarantee the market return. If you are paying a manager to perform better than the market and the investment doesn’t have a positive relative return, start shopping for a new fund!

Relative return can also be used within a smaller context. For example, a technology fund’s performance could be benchmarked against other technology funds. In today’s market, absolute returns may not have much meaning because of the bullish conditions. They may not enable you to evaluate the fund’s performance. Relative returns enable us to know the true return earned by the fund over and above the market-linked returns.

Do your homework before you shop.

Peer returns

Another dimension to returns is peer returns. Your fund may give a return of more than 50 per cent in a year. However, peer funds, that is, funds in the same category, may have given higher returns. Relatively speaking, your fund hasn’t performed all that well!

(The author is a freelance writer.)

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