Excess return, also known as alpha or abnormal return, refers to the return on an investment that exceeds the return on a benchmark or a risk-free rate. It is a measure of the investment’s performance beyond what would be expected given the level of risk associated with it. Excess return is a key concept in finance and investment analysis, particularly when evaluating the performance of investment portfolios or individual securities.
Here are a few key points about excess return:
1. **Calculation:** Excess return is calculated by subtracting the benchmark return or risk-free rate from the actual return of the investment. Mathematically, Excess Return = Actual Return – Benchmark Return or Risk-Free Rate.
2. **Benchmark:** The benchmark is a standard against which the performance of an investment is measured. It could be a market index, such as the S&P 500 for stocks, a bond index for fixed income securities, or any other relevant benchmark depending on the asset class.
3. **Positive and Negative Excess Return:**
– A positive excess return indicates that the investment outperformed the benchmark or risk-free rate.
– A negative excess return indicates underperformance compared to the benchmark or risk-free rate.
4. **Risk-Adjusted Performance:** Excess return is often used as a measure of risk-adjusted performance. It helps investors assess whether the return generated by an investment is commensurate with the level of risk taken.
5. **Alpha:** In the context of portfolio management and performance evaluation, excess return is often referred to as alpha. Positive alpha suggests that the portfolio manager has added value through skillful investment decisions, while negative alpha indicates underperformance.
6. **Active Management:** Excess return is particularly relevant in the context of actively managed investment portfolios. Portfolio managers aim to generate positive excess returns by making investment decisions that outperform the market or their chosen benchmark.
7. **Risk-Free Rate:** In some cases, the risk-free rate, such as the yield on government bonds, is used as a benchmark. The excess return over the risk-free rate provides a measure of the risk premium associated with the investment.
8. **Evaluation of Investment Strategies:** Excess return is a crucial metric for evaluating the success of investment strategies. It helps investors and portfolio managers assess whether the returns achieved are due to skillful decision-making or simply a result of taking on more risk.
Overall, excess return is a valuable metric for investors seeking to understand the performance of their investments in relation to a benchmark or risk-free alternative, and it plays a central role in performance evaluation and portfolio management.