Relative Return

Relative Return is the performance of an investment or portfolio measured against a specific benchmark, such as a stock market index. It essentially answers the question, “How did my investments do compared to the market?” If your portfolio gained 10% in a year when the S&P 500 index gained 8%, your relative return is a positive 2%. Conversely, if your portfolio only gained 5% in that same year, your relative return is a negative 3%, even though you still made money. This metric is the primary yardstick used in the professional fund management world to gauge success. The portion of the relative return that can't be explained by market movements is often referred to by its more technical name, alpha. While it's a useful tool for comparison, a relentless focus on relative return can sometimes lead to poor decision-making, a topic that value investors view with healthy skepticism.

Imagine you've hired a professional money manager for your mutual fund. You're not just paying them management fees to earn a positive return; you're paying them to be smarter than average. In the investment world, “average” is often represented by a market index. The manager's entire job is to generate a positive relative return—to “beat the market.” This concept turns investing into a competitive sport.

• Your portfolio's return is your score.
• The benchmark's return is the score to beat.

This framework is the bedrock of the active management industry, from mutual funds to multi-billion dollar hedge funds. Their marketing, their bonuses, and their very existence often depend on their ability to consistently outperform a chosen benchmark. When they succeed, they can boast about their skill. When they fail, they risk losing clients to competitors or, increasingly, to cheaper passive investments that simply track the benchmark.

For a value investor, an obsession with relative return is a red flag. The philosophy championed by legends like Benjamin Graham and Warren Buffett is rooted in absolute return—the actual gain or loss on your investment, irrespective of what a benchmark is doing. The goal is to buy great businesses at sensible prices, not to win a quarterly horse race against an index.

Fund managers who are judged solely on relative performance face a difficult choice. If they construct a portfolio that looks very different from the benchmark (a high active share), they might outperform dramatically. However, they could also underperform dramatically, a phenomenon known as “career risk.” Getting it wrong for even a short period can get them fired. This pressure often leads to a perverse outcome: “closet indexing.” A manager might secretly hug the benchmark, constructing a portfolio that is very similar to the index to ensure they don't stray too far from its performance. They continue to charge high fees for “active” management while delivering little more than an expensive index-tracking service. They are incentivized to avoid losing rather than to win big.

A value investor's primary goals are to achieve a satisfactory absolute return over the long term and, most importantly, to avoid a permanent loss of capital. This requires a focus on business fundamentals, competitive advantages, and a strict adherence to a margin of safety.

• If the market is in a bubble and soaring 30%, a prudent value investor might underperform by only gaining 10% as they cautiously avoid overpriced stocks. In relative terms, they look like a failure. In absolute terms, they've protected capital and earned a solid return.
• When the bubble bursts and the market crashes 40%, that same investor might only lose 5%. Their relative return is a stunning +35%, but their real victory is the preservation of capital in a storm.

Focusing on relative returns forces you to dance to the market's tune. Value investing is about letting the market's manic-depressive swings serve you, not the other way around.

The math is straightforward. Formula: Relative Return = Your Portfolio's Return - The Benchmark's Return Example 1: Outperformance

• Your Portfolio's Return: +12%
• Benchmark Return (e.g., MSCI World Index): +9%
• Your Relative Return: 12% - 9% = +3%

Example 2: Underperformance

• Your Portfolio's Return: +20%
• Benchmark Return (e.g., NASDAQ Composite): +25%
• Your Relative Return: 20% - 25% = -5%

In the second example, you made an excellent 20% return in absolute terms, but relative to the high-flying tech index, you “failed.”

• Know the Game. When you invest in an actively managed fund, understand that your manager is likely playing the relative return game. This can influence their decisions in ways that may not always align with your personal financial goals.
• Focus on Your Goals. Don't get caught up in whether you “beat the market” every year. The more important questions are: Is my portfolio growing enough to meet my retirement needs? Am I taking an appropriate amount of risk? Am I protected from catastrophic loss?
• Consider the Alternative. For most investors, the evidence suggests that buying and holding a low-cost index fund or ETF is a superior strategy. It guarantees you will capture the market's return (a relative return of zero, before tiny fees) and frees you from the high costs and frequent disappointment of trying to find a manager who can consistently outperform.
• Think Like an Owner, Not a Renter. Value investing is about owning a piece of a business for its long-term prospects. Relative return thinking is about “renting” stocks for short-term performance. The former builds wealth; the latter often just creates anxiety and fees.