Absolute return is the measure of the gain or loss on a portfolio expressed as a percentage of the invested capital, as opposed to relative return, which measures gains and losses in terms of a benchmark.

Q. This is one of those phrases we hear more frequently lately, but it seems that different people use it different ways. What’s the real meaning?
A. The basic meaning is really simple: the total gain or loss on a portfolio. It’s a term that originated in the early days of hedge funds and alternative investments. The point was to distinguish between actual, total investment results—a portfolio’s “absolute return”—and “relative returns” which are common in, say, the traditional, long only mutual fund world.

Q. Right, in that world, performance is usually measured by how well a manager does relative to a benchmark, like the S&P. But why does the hedge fund world like to use this different standard?
A. Aside from a basic way of measuring returns, the term effectively emphasizes that traditional stock and bond indexes only are telling a part of the investment story. First off, of course, shorting is very common in hedge funds, but extremely limited inside mutual funds. Secondly, hedge fund managers can be a lot more aggressive with leverage to magnify their returns than can traditional asset managers. Third, more broadly speaking, as anyone who watches MM knows, there are a whole world of other strategies and asset classes that alternative managers argue investors should have exposure to.

Q. But you’ve been comparing hedge funds focused on absolute returns with mutual funds focused on relative returns. Is that distinction still really valid? There are lots of mutual funds now that pursue hedge-fund type strategies…
A. Very true. That wasn’t true before, but is increasingly so. Some mutual funds have started using swaps, derivatives and other instruments to effectively increase their ability to use leverage, or to short securities. And some actually allocate money to sub-advisors who are hedge fund managers to gain access to their strategies. So, the traditional distinctions are really beginning to blur.

Q. And, as we talk about on this show, there are now many other ways for investors to get alternatives exposure as well. Things like registered hedge funds, funds of funds, certain kinds of ETFs, managed futures accounts, MLPs, Royalty Trusts…
A. Yes, yes, really, the whole financial industry is undergoing a transition towards alternative strategies. That’s exactly why you hear the phrase “absolute return” so much these days. “It’s an absolute return fund” is code for: “we invest in alternative strategies”. But it no longer tells you the fund is a hedge fund, as it used to.