Definition of Absolute Return
Absolute Return refers to the actual return earned by an investment over a period of time without considering any relative benchmark or any other measure of performance. It is the simplest form of comparing return from an investment and is also known as Total Return. It can be positive or negative and can be for any period, and it doesn’t take into consideration any other market-related factor in its computation.
It is a measure of how much the initial investment has become without taking into consideration the period in its computation. Further, this measure is a straightforward process with no relative measure against any benchmark, which makes this measure of return receive a lot of criticism. Also, since returns are measured in absolute terms, it can provide misleading results on a lower base compared to a higher asset size base.
One can access the Absolute Return of any popular Fund, and usually, over a longer time frame, a positive return is found; however, if one adjusts the same with inflation, then real returns might be negative in many cases or low single digits, and that is one of the drawbacks of using Absolute return.
Let’s understand the same with a simple example.
Two funds, A and B, generate Absolute return of 20% over the five years with an initial investment of $100000 each, becoming $12ooooo in the five years. However, on close observation, it was observed that Fund A is having a Standard Deviation of 1 whereas Fund B has a Standard Deviation of 3, which highlights that Fund B is more volatile and, as such, should provide a better risk-adjusted return. However Absolute Return measure doesn’t consider this factor and focuses only on the absolute return. So comparing the two funds from an Absolute return perspective may give an identical result; however, when observed on other parameters, it is clear that Fund A is better.
How Does It Work?
Absolute Returns work by deploying strategies to generate positive returns. However, since this return measure doesn’t have any relative benchmark to compare with, it deploys tools like entering into derivative trades such as Futures and Options, undertaking short-selling wherever permissible as well as doing arbitrage trade. Further, it can only be measured in terms of percentage return generated, which leads to negative biases towards funds with a large asset base compared to funds with a small asset base.
The formula for Absolute Return:
The formula to compute Absolute return is very simple and straightforward, as shown below:
Absolute Return= (Selling Price – Cost Price) * 100 / Cost Price
It is expressed in percentage form and can be positive or negative depending upon the returns.
Examples of Absolute Return
Let’s understand the same with the help of a simple example.
ABC Limited purchased the stock of Apple Inc on the following dates as mentioned below along with dividend received dates and sold the entire holding on 31st Dec 2019 @ $100 per share. Based on the same, let’s compute the Absolute Return for ABC limited.
|Date||Quantity Purchase||Price per unit||Total Purchase Price|
|Total Aggregate Investment||$688,800|
Details of dividends Received during the year are as follows:
|Date||Dividend received per share||Holding Quantity||Dividend Received|
|Aggregate Dividend Received||$8,640.00|
Accordingly Absolute Return is computed as follows:
Absolute Return = (Selling Price + Dividend received – Cost Price) * 100 / Cost Price
- Absolute Return = ($910000+$8640-$688800)*100/$688800
- Absolute Return = 33%
It offers multiple advantages. A few of the noteworthy are enumerated below:
- First, it is very simple to calculate and understand for all users.
- Second, it is unaffected by period and any benchmark comparison and provides returns generated in true terms.
- Third, it helps in reducing overall volatility as it doesn’t consider intermittent changes.
It suffers from various shortcomings as enumerated below:
- It is a fault measure when comparing along with different time frames.
- It isn’t easy to compare across different asset classes.
- It doesn’t compare against any benchmark, which results in determining the relative performance. Also, absolute return lacks adjusting returns for inflation, leading to negative returns despite absolute returns showing a positive value.
- It can lead to the selection of those investments where risk is higher as it doesn’t consider risk measures such as Standard Deviation and other performance ratios such as Sharpe Ratio, Treynor Ratio, etc.
- It measures doesn’t allow investors to assess the efficacy of the Fund manager and whether they can generate positive alpha. Also, this measure completely avoids assessing risk-adjusted returns.
- It is not comparable, which makes it an effective measure of performance.
Absolute Return vs Relative Return
Absolute Return is different from Relative Return. Major Key differences are enumerated below:
|Definition||It is the return generated more than the investment made.||It is the return generated compared to the benchmark against which the fund has been benchmarked with.|
|Performance Attribution||It can be positive or negative. A negative return implies negativity.||It can also be positive or negative; however, it can have a negative return despite generating a positive absolute return.|
|Risk-Adjusted Return||It doesn’t provide any risk-adjusted return and doesn’t even measure the underlying risk.||It provides a risk-adjusted return and also helps in comparing return versus market performance.|
|Focus||It is short-term focused and strategies deployed are also to make short-term gains.||Relative is more long-term focused.|
It is an actual return measure that doesn’t consider any period or benchmark for performance measurement in relative terms. Instead, it compares only absolute returns, which can lead to misleading results at times on account of large asset size, favorable or adverse market conditions as well as risk undertaken in generating the absolute returns; however, despite the shortcomings, this measure of return is frequently used in conjunction with other performance measures.
This is a guide to Absolute Return. Here we also discuss the definition and how does absolute return work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –