Excess Return

Definition

Excess return refers to the investment performance that exceeds the expected or benchmark return. It represents the additional return an investor earns above the market or a specified benchmark, providing a measure of the value added by an investment strategy or manager.

5 Must Know Facts For Your Next Test

1. Excess return is a key metric used in performance evaluation and attribution analysis to assess the value added by an investment manager or strategy.
2. Positive excess return indicates that the investment has outperformed the benchmark, while negative excess return indicates underperformance.
3. Excess return can be calculated as the difference between the actual return of an investment and the expected or benchmark return over a specific time period.
4. Analyzing excess return is crucial in evaluating the effectiveness of active investment management and making informed decisions about portfolio allocation.
5. Excess return is often used in conjunction with other performance measures, such as Sharpe ratio and information ratio, to provide a more comprehensive assessment of an investment's risk-adjusted performance.

Review Questions

• Explain the concept of excess return and its significance in the context of performance measurement.
  • Excess return refers to the investment performance that exceeds the expected or benchmark return. It represents the additional return an investor earns above the market or a specified benchmark, providing a measure of the value added by an investment strategy or manager. Analyzing excess return is crucial in evaluating the effectiveness of active investment management and making informed decisions about portfolio allocation. Positive excess return indicates that the investment has outperformed the benchmark, while negative excess return indicates underperformance. Excess return is often used in conjunction with other performance measures, such as Sharpe ratio and information ratio, to provide a more comprehensive assessment of an investment's risk-adjusted performance.
• Describe the relationship between excess return and the concept of alpha. How can these two measures be used together in performance evaluation?
  • Excess return and alpha are closely related concepts in the context of performance measurement. Alpha is a measure of the active return on an investment, gauging how much a manager's forecasts or investment strategies have added to or subtracted from the portfolio's return. Excess return, on the other hand, represents the investment performance that exceeds the expected or benchmark return. While excess return focuses on the overall outperformance or underperformance of an investment, alpha specifically quantifies the value added by the investment manager's active decisions and strategies. By using excess return and alpha together in performance evaluation, investors can gain a more comprehensive understanding of an investment's risk-adjusted performance and the sources of its returns, allowing for more informed decision-making about portfolio allocation and the selection of investment managers.
• Discuss the importance of using a relevant benchmark when calculating and interpreting excess return. How can the choice of benchmark impact the assessment of an investment's performance?
  • The choice of benchmark is crucial when calculating and interpreting excess return, as it directly affects the assessment of an investment's performance. A relevant benchmark should accurately represent the market or investment universe against which the performance of the investment is being measured. If the benchmark is not well-aligned with the investment's strategy or risk profile, the calculated excess return may not provide an accurate reflection of the value added by the investment manager. For example, if a growth-oriented investment is compared to a broad market index that is heavily weighted towards value stocks, the excess return may be skewed and not truly representative of the investment's performance relative to its peers or a more appropriate benchmark. Therefore, the selection of a suitable benchmark is essential for ensuring that excess return is a meaningful and reliable metric for evaluating an investment's performance and making informed decisions about portfolio allocation.

Related terms

Alpha: Alpha is a measure of the active return on an investment, gauging how much a manager's forecasts or investment strategies have added to or subtracted from the portfolio's return.

Benchmark: A benchmark is a standard against which the performance of a security, mutual fund, or investment manager can be measured. It is often an index or a combination of assets that represent a particular market or segment.

Risk-Adjusted Return: Risk-adjusted return is a measure of an investment's return that accounts for the level of risk involved. It allows for a more meaningful comparison of performance across different investments or portfolios.