23 – L1 22 Relative Returns V2

There are two ways that funds are evaluated on their performance, relative versus absolute returns. Relative returns refer to how the fund compares to a benchmark, which is usually an index. Mutual funds, both active and passive, are evaluated relative to their benchmark. Let’s say for example, that an actively managed fund chooses to focus on a portfolio of stocks that are also listed in the S&P 500 index. If the S&P 500 has an annual return of two percent and the fund returns three percent, then the fund outperformed its benchmark by one percent, and we say that the relative return was one percent. Since this is an actively managed fund, we also refer to this relative return as the active return. For a passively managed fund, the performance is based on how closely the fund attracts index. For example, if the S&P 500 had an annual return of two percent, and so did the passively managed fund, then the fund is meeting its investment objective. The relative return is zero, and since this is a passively managed fund, we say that the fund has a zero percent tracking error.