Key Takeaways
- Excess return shows investment outperformance.
- Also known as alpha or active return.
- Measured against benchmarks or risk-free rates.
- Higher excess return may involve greater risk.
What is Excess Return?
Excess return measures how much an investment outperforms or underperforms a benchmark, risk-free rate, or expected return based on risk. It is a key indicator used to evaluate the added value a portfolio or fund manager generates beyond passive market exposure, sometimes referred to as abnormal return or alpha.
This metric helps investors understand whether returns are due to skillful management or market movements, providing insight into the true performance of your investments.
Key Characteristics
Excess return can be broken down into several important attributes that clarify its role in investment analysis:
- Benchmark comparison: Represents the difference between a portfolio’s return and a specific benchmark, such as a market index.
- Risk adjustment: Incorporates models like the Fama and French Three Factor Model to isolate manager skill from market risk.
- Risk-free rate basis: Measures returns over the risk-free rate, indicating if risks taken justify the rewards.
- Indicator of manager skill: Positive excess returns suggest outperformance, while negative values indicate underperformance relative to peers.
- Influence of idiosyncratic risk: Excess returns may include company-specific risks that can amplify gains or losses.
How It Works
Excess return is calculated by subtracting the benchmark or expected return from the actual return of an asset or portfolio. This can be a simple arithmetic difference or adjusted for risk using models such as the Jensen’s Measure, which accounts for systematic risk via beta.
By understanding excess return, you can assess whether a fund or strategy is truly adding value above market trends and risk exposure. It also helps differentiate between returns driven by market beta and those driven by alpha, guiding more informed investment decisions.
Examples and Use Cases
Here are practical scenarios illustrating excess return in action:
- Exchange-traded funds: Comparing an ETF’s return to the underlying index can reveal excess return after fees, relevant when evaluating funds like SPY.
- Airlines: Companies such as Delta may produce excess returns relative to industry benchmarks, reflecting management effectiveness or unique market positioning.
- Dividend-focused investments: Selecting ETFs from the best dividend ETFs can target consistent excess returns through income and growth.
Important Considerations
While excess return is a valuable metric, it is backward-looking and depends heavily on the chosen benchmark and risk model. Investors should ensure benchmarks align with investment objectives to avoid misleading conclusions.
Additionally, excess returns might stem from idiosyncratic risk, which can increase volatility and potential losses. Evaluating excess return alongside other measures like tracking error or the Sharpe ratio strengthens your understanding of risk-adjusted performance.
Final Words
Excess return reveals whether your investment truly outperforms its benchmark after adjusting for risk. To make the most of this insight, compare your portfolio’s excess return against peers and consider consulting a professional to evaluate if the added risk aligns with your goals.
Frequently Asked Questions
Excess Return measures how much an investment outperforms or underperforms a benchmark, risk-free rate, or expected return. It shows whether a portfolio or fund delivers additional gains beyond standard market expectations.
Total return includes all gains or losses from an investment, while Excess Return focuses specifically on the 'extra' performance relative to a benchmark or risk-adjusted expectation. This helps isolate manager skill or strategy effectiveness.
Common types include arithmetic excess return, which is the simple difference between portfolio and benchmark returns; risk-adjusted excess return (alpha), which accounts for expected returns based on risk models like CAPM; and excess return over the risk-free rate, assessing if returns justify risk.
Higher Excess Returns often come with increased risks such as market volatility or idiosyncratic risk. Evaluating Excess Return alongside measures like beta or tracking error helps determine if outperformance is due to skill or simply higher risk exposure.
Investors look at Excess Return to evaluate whether a manager consistently beats the benchmark after adjusting for risk. Positive excess, especially risk-adjusted alpha, indicates skillful management, while negative excess suggests underperformance.
Excess Return formulas vary by type, including the simple difference between portfolio and benchmark returns, and risk-adjusted formulas like CAPM alpha which subtract expected returns based on market risk. Multi-period returns are often annualized using geometric averages.
Yes, negative Excess Return means the investment underperformed its benchmark or expected return. This signals poor relative performance and may indicate that the strategy or manager did not add value after accounting for risk.
