What it means
A headline return means very little on its own, because context determines whether it is impressive. Earning 8% when safe bonds pay 2% is a strong outcome, while earning the same 8% when the market as a whole returned 15% is a poor one.
Excess return supplies that context by subtracting the appropriate comparison from the raw figure. There are two comparisons in common use, and mixing them causes confusion.
Measured against the risk-free rate, excess return shows the compensation earned for taking any risk at all, and it is the version used inside performance ratios. Measured against a market benchmark, it shows whether an investor added value through selection and timing, and in that form it is often called active return or alpha.
The measure matters commercially because fees usually depend on it. Fund managers, private equity partners and internal investment teams are frequently paid a performance fee only on the return above an agreed benchmark or hurdle.
Defining the comparison precisely therefore has real money attached to it. Interpreting the number requires attention to the risk taken to produce it.
A manager who beat the benchmark by 4% while holding far riskier assets has not necessarily done well, which is why analysts pair excess return with measures such as the Sharpe ratio and information ratio. Those ratios divide the excess return by the volatility incurred to earn it.
Two nuances trip people up regularly. First, excess return should be measured after fees and costs, since a 2% gross outperformance can vanish entirely once charges are deducted.
Second, a single good year proves little, because random variation across a large group of managers guarantees that some will look brilliant purely by chance.
In practice
Real-world examples.
Example
A charity's investment committee reviews a manager who returned 6.8% in a year when the benchmark returned 7.4%. Despite a positive headline number, the negative excess return of 0.6 points triggers a formal review of the mandate.
Example
A private equity fund agrees to keep 20% of profits above an 8% annual hurdle. On a fund returning 15%, the performance fee applies only to the 7 point excess return, not to the full amount.
Example
A corporate treasurer compares a short-term deposit paying 4.6% against the 4.3% risk-free rate. The 0.3 point excess return is deemed too thin to justify locking the cash away for six months.
Think of it
“Excess return is what you earn above expectations-your outperformance versus a benchmark or requirement.
Formula
Calculation
Excess return = portfolio return - benchmark return
Or, when measured against cash: excess return = portfolio return - risk-free rate
A pension fund's equity portfolio returned 12.4% over the past year. Its agreed benchmark, a broad national share index, returned 9.1% over the same period. The risk-free rate was 4.0%.
Excess return against the benchmark = 12.4% - 9.1% = 3.3 percentage points
Excess return against cash = 12.4% - 4.0% = 8.4 percentage points
The portfolio holds $2,000,000. In money terms, the outperformance against the benchmark is $2,000,000 x 0.033 = $66,000.
Now allow for costs. The manager charges a 0.9% annual fee, which reduces the portfolio return to 12.4% - 0.9% = 11.5%, and the net excess return against the benchmark falls to 11.5% - 9.1% = 2.4 percentage points, or $48,000 on the same $2,000,000.Case study
Seen in the real world.
Pemberton Wells Endowment is an imagined institution used for this illustrative example. Its trustees had been delighted for three years running, because the portfolio returned 11%, 14% and 9% respectively and every annual report opened with those figures.
A new trustee with an investment background asked a simple question: what did the benchmark do? The answers were 13%, 16% and 11%, meaning the endowment had produced negative excess returns of 2 points in each of the three years. Against $180,000,000 of assets, that shortfall amounted to roughly $10,800,000 of value that a plain index fund would have delivered for far lower fees.
The trustees restructured the portfolio, moving 60% into low-cost index holdings and retaining active managers only in two specialist areas where the case for outperformance was strongest. Reported returns did not leap, but excess return turned mildly positive, annual fees fell by $900,000, and the committee's reporting pack now shows benchmark comparisons on the first page rather than the eleventh.
Watch out
Common mistakes.
- Judging performance on the headline return alone without asking what the relevant benchmark did over the same period.
- Measuring excess return before fees, which overstates the value an active manager has actually delivered to the investor.
- Choosing a flattering benchmark that does not match the portfolio's actual risk and asset mix, making ordinary results look exceptional.
Questions
People also ask.
Is excess return the same as alpha?
They are related but not identical; alpha is the excess return remaining after adjusting for the risk taken, whereas plain excess return makes no such adjustment.
Can excess return be negative?
Yes, and it frequently is, since a majority of active managers fail to beat their benchmark consistently after costs.
Over what period should it be measured?
At least three to five years, because a single year contains far too much random variation to distinguish genuine skill from good fortune.
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