Excess Return
Excess return, also known as alpha or abnormal rate of return, is the portion of an investment’s return that exceeds the expected return given its level of risk as measured by a benchmark or a relevant index.
For example, if a stock portfolio’s return is 12% in a year while the return on a benchmark index (such as the S&P 500) is 10%, the portfolio’s excess return is 2% (12% – 10%).
Excess return can be positive or negative. Positive excess return indicates the investment has outperformed its benchmark or the expected return given its risk level, while negative excess return indicates underperformance.
In the context of the Capital Asset Pricing Model (CAPM), excess return is the difference between the return on an investment and the return on a risk-free asset, such as a U.S. Treasury bond.
Excess return is used in performance evaluation. Active portfolio managers, for instance, aim to generate positive excess returns over their benchmarks. On the other hand, passive investment strategies typically aim to match, not exceed, their benchmarks.
Example of Excess Return
Let’s take an example of a mutual fund’s performance.
Assume you have invested in a mutual fund, and over the past year, the fund has generated a return of 15%. The benchmark index, against which the fund’s performance is evaluated, has returned 10% during the same period.
In this scenario, the excess return of the mutual fund is the difference between the actual return of the fund and the return of the benchmark index, which is 15% – 10% = 5%.
This means that the fund has outperformed its benchmark by 5%. This is considered a positive excess return, indicating that the mutual fund manager’s investment decisions have resulted in better performance compared to the market benchmark.
Keep in mind, however, that past performance is not a guarantee of future results, and it’s important to consider other factors, such as risk and expenses, when evaluating investment options.
