Absolute vs. Relative Returns

Anyone who's attended my classes or speaking engagements has heard me refer to "absolute" returns and "relative" returns. Let's talk about what they are and why they're important.

Have you ever seen a mutual fund advertisement or prospectus? In the performance section you'll often see the returns listed on a 1yr, 3yr, 5yr and 10yr basis. Often there will also be a comparison of the mutual fund to an index, like the S&P 500. Or it may compare the fund to the average of all it's "peer" funds, which are in a similar category, like Large Cap Value.

So you may see something like this:

Fund XYZ 3yr 6.3% (+1.3% vs. S&P500) and 5yr 7.9% (-2.7% vs. S&P500)

What this is saying is that over the last 3 years and 5 years, Fund XYZ has averaged 6.3% and 7.9% per year, respectively. The part in parentheses means that those returns were on average 1.3% better than the S&P 500 over the last 3yrs and 2.7% worse than the S&P 500 over the last 5 years. In other words, the performance RELATIVE to the S&P500.

So what does this mean Tommy?

It means that this fund and the fund manager are measured or "benchmarked" against the S&P500. In other words, any performance incentives are likely tied to beating the market or benchmark, not necessarily providing good returns. If the S&P 500 lost 22.3% in a year (like in 2002) and this fund returned -19.9%, that would be a big win for the portfolio manager (+2.4% vs. S&P 500).

I don't know about you, but I'd be upset if a portfolio manager got a bonus for losing 19.9% of my money!!!

ABSOLUTE returns on the other hand, means positive returns regardless of what the S&P 500 did or any other measure. It means moving forward in any market environment, interest rate level or inflation period.

But Tommy, you can't have positive returns every year! That's crazy! You have to suffer through some losing years. That's why you diversify and invest for the "long-term"!

Believe that if you want, but there are literally thousands of funds out there that produce solid positive returns each and every year. Some are focused on the U.S. markets, some on international markets. Some are invested in stocks only, while others diversify into commodities or private equity.

Tommy, why haven't I read about these mutual funds before?

Because they're not mutual funds, they're hedge funds.

Let me tell you why I think hedge funds are perhaps the best investment vehicles out there. First, true hedge funds are all about risk management. Without the limits imposed on mutual funds, hedge funds are able to actively manage risks by diversifying their strategies and using alternative investments, like options and futures. With these tools managers can set up scenarios where they profit from up, down or sideways markets.

Secondly, the performance bonuses paid to hedge fund managers are based entirely on the amount of net positive returns. And this doesn't reset each year like mutual funds. The positive returns have to be above any previous high-water mark! Unless the manager controls risk in volatile markets and takes advantage of opportunities (long and short) there's no bonus paid.

That's why we use many of the same techniques at TS Financial. We figure the reason people pay us is to make them real money, not relative money.

Don't you want someone who's interests are the same as yours, not losing money and making money each year?

Absolutely.