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What is Absolute Return and how is it measured?
Absolute Return is simply the return generated by an investment vehicle. For example, the returns generated by bonds are their absolute return. Absolute Return is not compared to any other measure of the market or benchmarks. It is a single entity and is related to the performance of the investments in the market.
Absolute Return Vs Relative Return
Absolute Return differs from Relative Return because, while calculating Relative Return, we have to take in consideration the returns of other investment funds that are active for a certain period of time.
Relative return compares the performance of the investment against market value, category of funds, and the market condition as a whole. An example of relative return can be found in the case of Mutual Funds. In mutual funds, the returns are compared to other players in the market and the benchmark of the returns.
In case of Absolute Return, the investment strategies opted include futures, short selling, derivatives, arbitrage, unconventional assets, and options. Absolute returns are single entities the value of which are calculated singly without comparing with any benchmarks.
Hedge Funds
The credit of creating the first absolute return vehicle goes to Alfred Winslow who created the first hedge funds in 1949. Hedge funds are a pool of investment products clubbed together. In the case of Hedge Funds, the fund managers raise funds by interacting with investors. The hedge fund's income is generated via a long-term strategy, such as buying common stocks and bonds.
Hedge funds specialize in given areas such as real estate, private equity, or patents. Although anyone can invest in hedge funds, it is the traditional investors who primarily invest in them.
How is "Absolute Return" Calculated?
Absolute return is calculated by the following formula −
$$\frac{Current\:Value\:-\:Purchase\:Value}{Purchase\:Value}\times100$$
For example, if an investor invests in real estate a sum of $ 85,000 and its value goes up to $105,000 over two years' period, the absolute return will be −
$$\frac{105,000 - 85,000}{85,000}\times100 = 23.53%$$
Points to Note
Absolute returns do not consider any comparison or benchmarks.
Absolute Return is simply the return generated by an investment vehicle.
Hedge Funds are a good example of an Absolute Return vehicle.
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