Definition
Excess return, in finance, refers to the difference between the return of an investment and the return of a benchmark. It is the profit over and above what was predicted based on the performance of the overall market or another specific standard. If the return is less than the benchmark’s return, the excess return can be negative, indicating underperformance.
Key Takeaways
- Excess Return, also known as Abnormal Rate of Return, is the return provided by an investment, trading strategy or fund over its expected return. This return surpasses the predicted normal rate given its risk or other similar activities.
- It is widely used as a performance measure for different investments. If an investment is generating an excess return, it indicates that the investment is outperforming the market or similar investments.
- Excess Return does not consider the risk associated with the investment. Therefore, an investment may be generating a high excess return, but it may also have a high level of risk. Investors must be careful about not considering excess return in isolation while making investment decisions.
Importance
Excess return, also known as “alpha”, is a crucial concept in finance because it measures the performance of an investment relative to a benchmark, such as a market index.
This indicator is important for investors and portfolio managers to determine the value that has been added or lost through their investing strategies.
An investment that consistently provides an excess return can signal strong management or a successful strategy.
Similarly, an investment that fails to meet the benchmark may require a change in management or strategy.
Therefore, assessing excess return is vital in the strategic decision-making process regarding investment portfolios.
Explanation
Excess return, also called “alpha” or “active return,” serves a significant purpose in the financial world as it evaluates the effectiveness of an investment or an investment strategy by determining the amount it has returned above or below a benchmark. This measure is widely used in stock portfolio strategies, mutual, hedge funds, and trading algorithms to quantify the additional value that these investment approaches bring against a specified baseline market index, such as the S&P 500 or an industry index.
Essentially, excess returns show the effectiveness of an investment manager’s decisions and the value they are capable of generating above a passive investment strategy. The use of excess return is not limited to assessing the performance of investments or strategies but stretches to evaluating the risk-adjusted returns of specific assets.
Investors use the measure to comprehend if the additional returns from a given investment warrant the risk taken beyond a risk-free asset, such as a Treasury bill. In this context, the excess return helps in formulating an investment decision by outlining the risk versus reward matrix.
By providing a mechanism to determine if an asset’s returns are essentially compensating for the risk taken, the excess return proves to be a critical component in strategic investment planning and risk management.
Examples of Excess Return
Excess return, also known as abnormal rate of return or alpha, is the difference between the actual return of an investment and the expected return given its risk level and market performance. Here are three real world examples:
Stock Investments: An individual invests in a tech company’s stock, which returns 12% over the year. However, the overall market average return for that year is 7%. In this case, the excess return on the tech company’s stock would be 5% (12% – 7%). This means the investor has earned an additional 5% return compared to what the market average was.
Mutual Funds: Suppose a mutual fund manager has a portfolio that records a return of 15% in a year, while the benchmark index (say, S&P500) against which the fund’s performance is measured, gives a return of 10%. The excess return, in this case, would be mutual fund return – benchmark return = 15% – 10% = 5%.
Bonds: A person purchases corporate bonds from a company that pays an annual interest rate (yield) of 6%. The risk-free rate (which is often the yield on government bonds) at the time is 3%. The excess return on the corporate bond investment would be 3% (6%-3%), showing the additional return the investor received in compensation for taking on the greater risk of a corporate bond versus a government bond.
Excess Return FAQ
What is Excess Return?
Excess return, also termed as abnormal rate of return or differential return, refers to the return provided by a given investment that exceeds the rate of return of a risk-free investment, such as a US Treasury bond. The excess return hence is the profit above the predictable returns of the risk-free investment.
How is Excess Return calculated?
The excess return of an investment can be calculated by subtracting the return of a risk-free investment from the return of the investment you are examining.
Why is Excess Return important in a portfolio?
Excess returns provide a measure of the additional profit a risky investment provides over a set benchmark. It essentially provides a comparison between the risk of investment and potential gains, enabling an investor to understand whether the added risk of an investment has the potential to pay off.
What risks are involved in pursuing Excess Returns?
Pursuing excess returns involves taking on higher-risk investments. Though these investments have the potential to yield high returns, they also carry the risk of substantial losses. Therefore, investors should carefully assess their risk tolerance and investment goals before pursuing excess returns.
Related Entrepreneurship Terms
- Alpha
- Risk-Adjusted Return
- Benchmark Index
- Capital Asset Pricing Model (CAPM)
- Sharpe Ratio
Sources for More Information
- Investopedia – A comprehensive web resource dedicated to investing and finance education.
- Corporate Finance Institute – Offers online courses and educational content related to corporate finance and investing.
- Morningstar – A leading provider of independent investment research in North America, Europe, Australia, and Asia.
- Fidelity – A broad financial services organization with a full range of products and services.
