Definition
Excess return, also known as abnormal rate of return or alpha, refers to the return on an investment that exceeds the predicted return of a financial model or benchmark. It’s the difference between the actual return and the expected performance of the investment, taking into account the risk as well as market movements. It serves as a measure of an investment’s performance and is used to evaluate the effectiveness of portfolio managers.
Phonetic
The phonetic spelling of “Excess Return” is: ɪkˈsɛs rɪˈtɜrn
Key Takeaways
- Definition: Excess return, also known as alpha, is the return earned by an investment or a portfolio that exceeds the expected return based on its risk level measured by beta. It is essentially the difference between the actual return of an investment and the expected return given the level of risk assumed.
- Measure of Performance: Excess return is commonly used as a measure of the performance of a fund manager or a trading strategy. A positive excess return indicates the manager or strategy has outperformed the market or relevant benchmark, while a negative excess return suggests underperformance.
- Risk and Return Consideration: While pursuing investments strategy or funds with high excess returns can be attractive, it’s important to understand these can also come with higher levels of risk. Therefore, it is crucial to consider the risk-adjusted excess return, which provides a more comprehensive view of performance by considering both the excess return and the risk taken to achieve it.
Importance
Excess return, also known as alpha or abnormal rate of return, is a crucial concept in finance as it measures the performance of an investment relative to a benchmark index or a risk-free rate of return, typically determined by government treasury yields. The excess return is important because it helps investors determine how much additional return they have earned or could earn for the extra volatility or risk borne, compared to a safer investment. This performance metric is used to evaluate the effectiveness of portfolio managers and to identify assets that provide high returns relative to their risk level. Understanding excess return can, therefore, facilitate more informed investment decisions, guiding the management and allocation of resources to achieve optimal portfolio performance.
Explanation
Excess return, also known as alpha or abnormal rate of return, is a critical performance indicator extensively used in the finance and investment sector. By comparing investment returns against a suitable benchmark such as an index, market average, or a relevant risk-free rate, it aims to evaluate the effectiveness of an investment strategy or the skill of a portfolio manager. Essentially, it measures the amount of return generated by an investment over and above the expected return. A positive excess return indicates that the investment has performed better than the benchmark, while a negative excess return suggests underperformance. Excess return is crucial because it serves to take into account the risks associated with an investment. This is in line with the risk-return tradeoff in finance theory that states – for higher risk, investors should expect higher returns. Investors and portfolio managers use this measure to make asset allocation decisions taking into consideration the risk-adjusted performance of different assets or investment strategies. Consequently, it provides a more comprehensive view of an investment’s performance, assisting investors in accurately understanding whether the risk assumption was worthwhile. Ultimately, the purpose of calculating excess return is to help investors identify higher-performing investments and strategies, enabling them to optimize returns on their investment portfolios.
Examples
Excess return, also referred to as alpha or abnormal rate of return, is the fraction of an investment or portfolio returns surpassing the risk-free rate or an index or benchmark performance. Here are three real-world examples:1. **Stock Market Investment**: Suppose an investor buys stocks from Company A and, over the course of a year, achieves a 15% return on their investment. If the risk-free rate (usually seen as the return of government bonds, such as the treasury bill rate) during the same period was 2%, the excess return that the investor earned would be 13% (15% – 2%).2. **Mutual Fund Performance**: Consider a portfolio manager who manages a mutual fund that gives a 20% annual return, while a benchmark index (for example, the S&P 500) returns 16% in the same period. The excess return of the mutual fund would be 4% (20% -16%). The manager has outperformed the market by 4%.3. **Real Estate Investment**: An investor buys a property and later sells it at a profit, achieving a return of 8% in 2 years. If the rate of 2-year government bonds as risk-free rate was 3% at the time of the investment, the investor would have an excess return of 5% on the real estate investment (8% – 3%). These examples underline the fact that investors typically seek out investments that offer the potential for excess return, assuming additional risk in the process.
Frequently Asked Questions(FAQ)
What is Excess Return?
Excess Return, also known as abnormal rate of return or differential return, represents the difference between an investment’s actual return and the expected return given its risk profile. It is usually used to evaluate the performance of a trader or fund manager.
How is Excess Return calculated?
It is calculated by subtracting the expected return or benchmark return from the actual or total return of the investment. If the value derived is positive, it indicates that the investment has outperformed the market. A negative value signifies underperformance.
What does a positive Excess Return signify?
A positive Excess Return implies that the investment has generated returns greater than those expected for the level of risk assumed, indicating a successful investment strategy.
What does a negative Excess Return mean?
A negative Excess Return means that the investment’s actual return was less than the expected return for the amount of risk taken, implying an unsuccessful investment strategy.
Can Excess Return be considered a measure of an investor’s skills?
Yes, Excess Return is often used as an indicator of the skill of an investor or fund manager. A consistently positive Excess Return might suggest superior investment skills.
Is higher Excess Return always better?
Typically, yes. A higher Excess Return indicates that the investment has performed better than expected given its risk level. However, it’s also important to consider the consistency of these returns.
How is Excess Return different from Absolute Return?
While Excess Return compares an investment’s performance to a benchmark or expected return considering its risk, Absolute Return measures the return an investment has generated over a certain period without considering risk or comparison to a benchmark.
Related Finance Terms
- Risk-Free Rate
- Asset Allocation
- Market Return
- Investment Portfolio
- Performance Evaluation
Sources for More Information
