What it means
Returns are rarely judged on their own. A fund that earns 9% sounds good, but if the market earned 12%, the fund fell short.
Performance is therefore measured against a benchmark, a standard such as a stock index that represents the opportunities available to the investor. When an investment beats its benchmark, the gap is often called excess return, and when it persistently does so after adjusting for risk, that skill is called alpha.
Many investors pay higher fees for managers who promise to outperform. The test is whether the extra return is greater than the extra fees and extra risk.
Outperformance can also refer to a company beating a target, a forecast or its competitors. A business that grows revenue by 15% in an industry that grows by 8% has outperformed its sector.
Managers are often rewarded with bonuses for beating their targets, which is why the choice of target needs care. As an analyst rating, outperform sits between a neutral hold and a stronger buy.
It expresses a view that a share should do better than the average of a group over a set period, often twelve months. Different firms use their own words and definitions, so the label cannot be compared across brokers without reading the key.
Be cautious about drawing conclusions from short periods. Outperformance in one year may be luck, and many funds that beat the market for a time fail to repeat it.
Sensible readers look at long records, consistent processes and net returns after fees. The choice of benchmark matters as much as the result.
A global shares fund compared with a small-company index will look very different from the same fund compared with a global index. Fair comparisons use a benchmark that matches the investment's real opportunity set, which is why mandates usually name the benchmark in writing.
In practice
Real-world examples.
Example
A pension fund trustee reviews a manager's results for the past five years. The fund returned an average of 8% a year against 7% for its benchmark. The trustee asks whether the one-point gain justified the higher fees, and whether it was earned by skill or by taking extra risk.
Example
A broker's research note rates a retailer's shares as outperform, meaning the analyst expects them to beat the sector average over the next twelve months. An investor uses the rating as a starting point and then reads the supporting analysis. She does not buy on the rating alone.
Example
A software company's sales director beats her annual target of $5,000,000 by 20%, selling $6,000,000 and earning a bonus. The CFO reviews the target-setting process to make sure that it was not set too low, since outperformance against a weak target says little.
Formula
Calculation
Excess return = investment return - benchmark return
Value of outperformance = excess return x amount invested
A portfolio of $1,000,000 returns 12% over a year, while its benchmark returns 9%. The excess return is 12% - 9% = 3 percentage points. The extra gain is 0.03 x 1,000,000 = $30,000. If the manager charged an extra fee of 1% (0.01 x 1,000,000 = $10,000), the net benefit of the outperformance falls to 30,000 - 10,000 = $20,000.Case study
Seen in the real world.
Ashgrove Capital is a fictional fund manager, and this story is illustrative. Its flagship fund returned 14% in a year when the market index returned 10%, and its marketing team proudly announced that it had outperformed.
The investment committee looked more closely. The fund had taken more risk than the index, with much larger swings, and after its 1.5% fee, the net return for investors was 12.5%, only 2.5 points ahead.
Over three years, the fund's advantage shrank to nothing as the extra risk caught up with it, and one investor who had added $500,000 on the strength of the first year's headline withdrew it again. The illustrative lesson is that outperformance must be judged after fees and after adjusting for risk, and across a long enough period to rule out luck.
Watch out
Common mistakes.
- Calling an investment a winner without naming the benchmark it was compared with.
- Ignoring fees and risk, which can turn apparent outperformance into underperformance.
- Reading too much into a single good year, when luck often plays a large part.
Questions
People also ask.
Does outperform mean the price will go up?
No, it means the investment should do better than the comparison, which could still fall but by less.
Is an outperform rating the same as a buy?
Not exactly, as firms define the labels differently, and outperform often signals a milder positive view than buy.
How long should I measure outperformance?
Several years is better than one, because longer periods smooth out luck and show consistent skill.
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