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Relative Returns vs. Absolute Returns

December 09, 2020
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Potential Equity Style Returns with Less Risk and Volatility

Much has been said about the wisdom of utilizing index portfolios/funds (whether mutual funds or ETFs) rather than managed portfolios due to the former’s lesser costs and its historical long-term over-performance over the latter. There are a multitude of studies espousing such merits, many finding that the general stock market (such as the S&P 500) beats managed portfolio solutions 80% of the time or more [1]. In fact, an annual study by Standard and Poor’s shows that 92% of actively managed funds trail their benchmark index after 15 years. So, goes the theory, if an S&P 500 index fund is cheaper and beats actively managed funds over 80% of the time over the long run, why wouldn’t we just utilize index funds?

In this post, we are not taking a side in this argument, but for the sake of the topic will simply presume that the studies are correct, and that using indexed portfolios can prove to be a better approach long-term. So, if we were to deposit our hard earned money we’ve earmarked for long-term growth objectives, such as retirement, into an array of index funds (whether equities and/or bonds), we would be adopting a passive approach and heavily subscribing to the oft-touted philosophy of “buy, hold, and pray it works out.” Because, they say, it always has worked out . . . eventually, though no one can seem to tell you when “eventually” is when a market downturn rears its head. Funny, that. What if tomorrow was your “eventually” because you were retiring tomorrow, but the market is currently in a downturn? The meltdown of 2008 still haunts many people, the utilization of index-funds notwithstanding.

With that as a backdrop, let’s examine relative and absolute return strategies.

Relative Return

Though the term might conjure up images of your mother-in-law coming over for a surprise visit, “relative return” is used to describe what most investors aim to achieve, especially when utilizing index portfolios. It is, in essence, doing what the market does, achieving 100% of the market upswings and downswings. This is a technical term called “capture.” In a relative return strategy, such as buying and holding an S&P 500 index fund, you (in theory) capture 100% of the market’s movements—up, down, or sideways. This can make for a very volatile ride but pretty much ensures achieving market returns.

So, if the market were to increase by 10%, your index fund would mimic that precisely (or very closely); conversely, if the market were to lose 10%, so would your holdings.

Relative return is as simple as that and is the most adhered to strategy by the investing public today, especially with the rise in popularity of index portfolios.

Absolute Return

Absolute return, on the other hand, seeks to limit the effect of downward market movements on your money while accepting a lesser portion of the upward movements. This, in effect, generally makes for a much less volatile (crazy-hair-pulling-ulcer-inducing) experience.

If the market were to decrease by 10%, perhaps an absolute return strategy might seek to limit its downside capture to only 50% of that movement, or a decrease of only 5% (half of the market’s downturn). The converse is also typical, where the market increases by 10% but an absolute return strategy might be content with capturing only half of that upswing. Thus, less volatility is experienced in both› types of market swings while aiming to achieve similar returns to the index over the long- term. The main advantage of absolute return strategies, then, is the width and depth of losses can be much less severe allowing for potentially much shorter recovery periods, if recovery is needed at all.

Analysis

While there is much we could say about the benefits of a “smoother ride” with respect to human behavior and the ability to more confidently plan for the future, we want to share some interesting statistics on how powerful absolute return strategies can be from a perspective of some simple financial math. After all, the question we normally receive when discussing this concept is, “Okay, but which one yields better results?”

Of course, this can only be answered from a historical perspective. Let’s consider the 50 year period of 1969-2019. Of course, the term “better” can be highly subjective, but let’s take the rate of return perspective for our analysis.

Most mistakenly believe that if you want to match an index’s returns, you need to capture 100% of its movements, both up and down. If you get all the downside capture, you better capture all the upside to equal the index (which, again, generally beats managed portfolios 80% of the time, so it’s an understandable goal to match/mirror the index). This is the essence of relative return and an index fund.

However, consider this: if you were able to limit your downside capture to 0, then you would only need 29% of the upward capture to equal the index/market. For example, assume the market declined by 10%, but you were able to achieve a 0% return during that period (no downside capture). Then, assume the market were to increase by 10%. In order to equal the market, you only need to capture 29% of that upswing (or +2.9%, as 2.9 is 29% of 10). See? If you can limit your downside capture, you only need a fraction of the upside capture.

Now, before you start breaking out your calculator to test this, you have to understand that this occurs over a wide period of years, not one month or one year to the next. From 1969-2019, if you never went down with the market, and only captured 29% of the upward swings (as a ratio) on a monthly basis, you would have come out equal to the index’s return but without any of the devastating losses due to market crashes along the way.

If you could limit your downside capture to only 20% (market declines by 10% but you only go down by 2%), then you only need 43% of the upside capture to equal the index (market increases by 10%, you increase by 4.3%). In table form, it looks like this [2]:


Capture of Monthly Downward Market MovementRequired Monthly Upside Capture to Equal Index
0%29%
20%43%
40%57%
60%71%
80%86%
100%100%

Many concern themselves with how they are doing “relative” to a market index (such as the S&P 500). However, the real answer might be to simply achieve positive returns (irrespective of the market’s performance) and limit downside capture to the greatest extent possible. This has the potential to achieve the same overall returns over time compared to relative return strategies (index funds/ETFs) without the stress of having to “beat or match the market” every year, not to mention a much lower Pepto Bismol cost.

Happily, there are strategies that contractually guarantee you against market losses in exchange for a lesser participation in the market upswings. For many, having part of their portfolio guaranteed against market losses while still having their earning potential tied to a market index (adhering to the vaunted index approach in spirit) provides a greater element of predictability as well as a much less volatile experience, all with the potential to still earn competitive market-driven returns.

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[1]https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html Last accessed 12-9-20.

[2] Crestmont Research, Capture! “Achieve Return, not ‘Beat-the-Market’”.https://www.crestmontresearch.com/docs/Stock-Capture-Graph.pdf Last accessed 12-9-20