Absolute return vs benchmark-relative investing: what the difference means for you

Two fund managers report their results for the year. The Australian share market has fallen 18%.

The first manager is down 15%. The second is down 4%.

By the standard the first manager is measured against, they have had an excellent year — they beat their benchmark by three percentage points, which over time is a strong result. By the standard the second manager is measured against, they have had a poor year, because they lost money.

Both statements are correct. They are simply answers to different questions, and understanding which question your portfolio is answering is more consequential than most investors realise.

What benchmark-relative investing means

Most institutional funds are managed relative to an index — the S&P/ASX 200 for Australian equities, the MSCI World for global. The manager’s objective is to outperform that index, and their performance, fees and often their job depend on the margin by which they do.

This has real advantages. It is transparent and measurable. It keeps the manager fully invested in the asset class you hired them for. And over long periods, equity markets have risen, so remaining invested has generally been rewarded.

It also produces a specific behavioural consequence: the manager’s risk is measured against the index, not against losing money. A benchmark-relative manager who moves substantially to cash because they believe the market is overvalued takes on enormous career risk. If they are wrong and the market rises, they underperform badly and lose mandates. If they are right, they merely match what a cautious investor could have achieved alone.

The rational response to that incentive is to stay close to the index. Which means when the index falls sharply, the portfolio falls too — and the manager has still done their job as defined.

What absolute return investing means

An absolute return approach sets the objective differently: to generate a positive return over a defined period, regardless of what the broader market does.

The measure is not a margin against an index. It is whether the portfolio grew.

That changes what the manager can do. Holding significant cash when opportunities look poor is a legitimate position rather than a career risk. Position sizes can vary with conviction. The portfolio need not own something merely because it is a large index constituent.

For an investor whose priority is preserving accumulated capital, the appeal is direct. If you have spent decades building wealth and are now more concerned with keeping it than compounding it as fast as possible, “we lost less than the market” is a weaker consolation than it sounds.

The trade-offs, stated honestly

Absolute return investing is not a superior approach. It is a different one, with its own costs, and any manager who presents it as free of trade-offs is overselling.

You will underperform in strong bull markets. A manager holding cash and maintaining defensive positioning will lag a rising market, sometimes by a wide margin, sometimes for years. This is the most common reason investors abandon an absolute return approach — and they usually abandon it at the worst moment, after a long rally and just before the conditions that justify the approach reappear.

The outcome depends more on manager judgement. An index fund’s result is determined by the index. An absolute return portfolio’s result is determined by decisions — when to hold cash, what to own, when to change. That is a genuine concentration of risk in the manager’s skill, and it is a legitimate reason for caution.

Performance is harder to evaluate. With no index to compare against, assessing whether a manager is adding value or simply taking different risks requires more work over longer periods.

A positive return is an objective, not a guarantee. No investment approach can promise positive returns. Absolute return strategies lose money in some periods. Any presentation suggesting otherwise should be treated as a warning about the manager rather than a feature of the strategy.

Why the distinction matters most at the wrong moment

The difference between these approaches is nearly invisible when markets rise steadily. Both approaches make money; the benchmark-relative manager probably makes more.

The distinction reveals itself in a sustained decline — and that is precisely when the consequences are largest, for two reasons.

Sequencing. A large loss early in retirement, when you are drawing on the portfolio rather than contributing, does lasting damage. The same percentage loss during accumulation, with years of contributions ahead, is far more recoverable. Two investors can hold identical portfolios and experience the same fall very differently depending on where they sit in that cycle.

The arithmetic of recovery. A portfolio that falls 40% requires a 67% gain to return to where it started. One that falls 15% requires 18%. The asymmetry is why capital preservation compounds in a way that is easy to underestimate — avoiding the deepest drawdowns matters more than capturing the strongest rallies for an investor whose priority is protecting what they have.

Which question is your portfolio answering?

Neither approach is right in the abstract. The useful question is which one matches your circumstances.

Benchmark-relative tends to suit long accumulation horizons, investors making regular contributions, those with the temperament to hold through significant declines, and portfolios where maximising long-run growth is the dominant objective.

Absolute return tends to suit investors at or near the point of drawing on their capital, those for whom a large drawdown would force a change in plans, and investors whose stated priority is preserving what they have accumulated rather than maximising what they might accumulate.

Most substantial portfolios contain elements of both, in proportions that ought to shift over time. The mistake is not choosing one — it is holding a portfolio built for one objective while actually needing the other, which happens quietly and is usually only discovered in a falling market.

Questions worth asking your adviser or manager

1. What is this portfolio’s stated objective — a margin above an index, or a positive return?

2. What is the largest drawdown this strategy has experienced, and over what period did it recover?

3. Under what conditions would you hold significant cash, and how would you explain that decision to me at the time?

4. How much would this portfolio need to fall before it changed my plans?

5. How are you remunerated, and does that align with the objective you have described?

Where advice fits

The choice between these approaches is not primarily a technical question about markets. It is a question about what your capital is for, when you will need it, and what a bad year would actually cost you.

Garnaut Private Wealth manages portfolios with an absolute return orientation, emphasising capital preservation and active management through market cycles. That approach suits some investors and not others, and establishing which is the case is the first conversation rather than the last.

You can read more about our Garnaut Absolute Return Theme and how it is applied.