Mutual Fund Analysis: Absolute vs Relative Returns

Absolute return calculations tell an investor the netl profit of an investment during a mutual fund analysis. Basically, the absolute return of a mutual fund is how much it earns over a given period of time. This is a simple calculation. A more profitable mutual fund will have a higher absolute return. However, returns on a mutual fund or any investment do not exist in a vacuum. Instead, they should be compared to other investments in order to determine their success rate. This is called relative return.

Relative Return Calculation

When you are looking to discover the relative return of an investment, you have to consider the basis of your comparison. What will your return be relative to? The market as a whole? Other mutual funds? Other mutual funds investing in the same products? The more you narrow this comparison, the more you can determine if your money could have gone farther by simply electing another fund. If you are comparing the fund to the market as a whole, then you will not gain much direction as to the decisions that could have made your investment more profitable.

Absolute Return Funds

There are certain funds that use only absolute return figures, and these focus on a narrow range of investments. Absolute return funds are not concerned with their success relative to others on the market. Instead, absolute return fund managers will employ techniques that are often seen as riskier. A mutual fund using the absolute model may engage in short selling, derivative-based trading, leverage or arbitrage. These techniques are slightly more complicated than traditional trading tactics, and they carry a much higher degree of risk. Therefore, it would be hard to compare an absolute return fund to one using traditional methods. Instead, the absolute model is used to show the actual return for the risk taken.

When to Use Relative Return Analysis

Most investors will be better off if they use the relative return model because it helps guide an investor. The method helps an investor decipher which mutual funds are out-performing the market, and when to consider moving to a new fund. This is particularly important if your fund manager leaves, for example, and you want to know if he or she is having more success with the new fund than your new manager is having with yours. By comparing the two very similar investment models to each other, you will learn which manager is making the wisest decisions.

When to Use an Absolute Return Analysis

If you are a sophisticated investor looking for riskier financial products, you may consider absolute return analysis as a model for choosing mutual funds. You will have to be comfortable with a level of risk and understand the market may outperform your mutual fund after some period of time. In the long run, however, the gains on your fund should be high enough to justify the additional risk with this straightforward kind of investing. Similarly, an absolute return analysis of even a standard mutual fund may be used by a sophisticated investor who has set expectations on returns, regardless of market performance.

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