In stock market investing, it might sound simple to determine whether or not a stock or a mutual fund is profitable. But it’s more challenging than you think for 401k investors to determine whether a fund manager or broker is doing a good job. Specifically, because it is difficult to define what’s “good” in the stock market.

“Good” depends on how the rest of the investment world is performing. For example, in a bull market, +2% is a horrible return. But in a bear market where most investors are down -20%, just preserving your capital would be considered excellent. In this case +2% doesn’t look so bad.

Before going any further let’s get some definitions out of the way:

Absolute return is simply whatever an asset or portfolio returned over a certain period of time.  For example, if a mutual fund returned +8% last year, then its absolute return was +8%. Pretty simple stuff.

Relative return on the other hand is the difference between the absolute return and performance of the market (or some other benchmark). To gauge the performance of the market, we use a benchmark index, such as the S&P 500 for large-cap global corporations, or the Russell 2000 to measure small cap stocks.

To use an example, if the absolute return of your portfolio was +10%, and during the same time period the performance of the S&P 500 was +6%, then you have a relative return of +4% greater than the market. If, however, during this same time period the S&P 500 returned +15%, then you have a relative return of minus -5% compared to the market.

If You Pay for Active Management, Then Get It

The rational behind this is that actively managed funds should get a return at least equal to the market. After all, you can by an index fund with a cheaper management expense ratio that will deliver the market return.

As an investor, you are paying an active management fee, so you expect the fund manager to perform better than the market.  If an investment does not have a positive relative return over a long period of time, it’s worth shopping for a new manager or considering an investment in lower-cost index funds.

Finally, we should also mention that relative return can also be used in contexts other than the entire market. It can be advantageous to look at the performance of a sector fund relative to the performance of its peers. For example, a technology fund’s performance would be measured relative to the entire technology industry. This is useful if the technology industry significantly outperformed or underperformed the market.

Thanks to the proliferation of ETFs, there are many indexes to choose from to measure specific industry sector performance.  But because many ETF-related indexes are very specific, an investor has to know the composition of each index.  The good news is that these indexes are very transparent and fully explained on the Web sites of the major ETF providers.