What Are Relative Returns and How Do They Work in Finance?

Investors and fund managers evaluate performance by comparing returns to a benchmark rather than looking at gains in isolation. This approach, known as relative returns, helps determine whether an investment has outperformed or underperformed the market or a specific index.

Understanding relative returns is essential for assessing risk-adjusted performance and making informed financial decisions.

Calculating Relative Returns

Measuring relative returns involves comparing an investment’s performance against a reference point to determine whether it has exceeded or lagged behind expectations. This can be done using different methods, each offering insight into how well an asset or portfolio has performed.

Return Ratios

One way to assess relative returns is through return ratios, which express gains or losses as a proportion of the initial investment or other financial figures. A widely used metric is the Sharpe ratio, which evaluates returns relative to risk by comparing excess return—return above a risk-free rate—to volatility. A higher Sharpe ratio indicates better risk-adjusted performance.

The Treynor ratio, another key measure, calculates returns relative to systematic risk using beta. Unlike the Sharpe ratio, which accounts for total risk, the Treynor ratio focuses on market-related fluctuations. These ratios help investors assess not just how much was earned but how efficiently those gains were achieved given the level of risk exposure.

Percentage Gains

Percentage gains measure the change in an investment’s value over a given period. This is done by subtracting the initial value from the final value, dividing the result by the initial value, and multiplying by 100.

For example, if an investment was worth $10,000 at the start of the year and increased to $12,500, the percentage gain would be:

(12,500 – 10,000) / 10,000 × 100 = 25%

While this method provides a clear picture of performance, it does not account for market conditions or risk levels. Investors often analyze percentage gains alongside other measures for a more complete view of investment success.

Benchmark-Based Measures

Evaluating performance against a benchmark is a widely used method for calculating relative returns. This involves subtracting the benchmark’s return from the investment’s return to determine the excess return.

For example, if a mutual fund delivered 8% in a year while the S&P 500 gained 6%, the relative return would be:

8% – 6% = 2%

Some investors also use risk-adjusted benchmarks, such as factor models that account for variables like company size, value versus growth orientation, or economic sector. The Fama-French Three-Factor Model refines comparisons by adjusting for risks inherent to different types of investments. Benchmark-based measures help investors determine whether an asset’s performance resulted from skill or broader market trends.

Comparing to Absolute Returns

Relative returns provide context by comparing performance to a benchmark, while absolute returns focus solely on the total gain or loss of an investment. Absolute returns measure the raw increase or decrease in value over a given period.

While absolute returns provide clear figures, they do not indicate whether an investment performed well relative to broader market conditions. A 10% gain may seem strong on its own, but if the overall market rose by 15%, that same return would indicate underperformance. Conversely, if the market declined by 5%, a 2% gain would signal resilience despite a seemingly modest increase.

Risk also plays a role in evaluating performance. An investment that generates a 12% absolute return may appear attractive, but if it required taking on excessive volatility or exposure to speculative assets, the risk-adjusted outcome might be less favorable. Relative returns incorporate risk metrics, helping investors determine whether the returns achieved were justified given the level of uncertainty involved.

Common Benchmarks in Use

Selecting an appropriate benchmark is essential when evaluating relative returns, as different asset classes and investment strategies require distinct points of comparison.

For equities, broad market indices such as the S&P 500 or Dow Jones Industrial Average serve as common references. Sector-specific indices, like the Nasdaq-100 for technology stocks or the Russell 2000 for small-cap companies, provide more tailored comparisons for investors focusing on particular industries or market segments.

Fixed-income investments rely on different benchmarks, as bond returns are influenced by interest rates, credit risk, and duration. The Bloomberg U.S. Aggregate Bond Index is widely used to gauge the performance of investment-grade bonds, while more specialized indices, such as the ICE BofA High Yield Index, track riskier corporate debt. Municipal bond investors may refer to benchmarks like the S&P National AMT-Free Municipal Bond Index, which excludes bonds subject to the alternative minimum tax.

Alternative investments, including hedge funds and private equity, often face challenges in benchmarking due to their complex structures and lack of daily pricing. Many hedge funds compare their returns to the HFRI Fund Weighted Composite Index, which aggregates performance across various hedge fund strategies. Private equity funds frequently use public market equivalents (PMEs) to estimate how their returns compare to publicly traded assets with similar risk characteristics.

Factors That Can Influence Outcomes

Market conditions play a significant role in shaping relative returns, as economic cycles, interest rate movements, and geopolitical events create environments where certain assets outperform or lag behind. During periods of high inflation, commodities and real assets often generate stronger returns than fixed-income securities. In a low-interest-rate environment, growth stocks may see outsized gains compared to value stocks. Timing and macroeconomic trends influence whether an investment’s performance appears favorable relative to broader market movements.

Fund management decisions also impact relative returns, particularly in actively managed portfolios where asset selection, sector allocation, and timing strategies determine whether a fund beats its benchmark. A portfolio manager who correctly anticipates shifts in consumer spending or technological advancements may generate excess returns, whereas poor sector allocation can lead to underperformance even in a rising market. Differences in investment philosophy—such as momentum-based trading versus contrarian investing—also contribute to variations in how returns compare to market indices.