Excess Return
Excess return, also known as abnormal return or alpha, refers to the return on an investment that exceeds a benchmark return, such as a market index or risk-free rate. For example, if a stock has an annual return of 10% and the market index has an annual return of 7%, the excess return of the stock is 3%. Excess return is commonly used to evaluate the performance of an investment, particularly in actively managed investment strategies, to determine whether an investment manager has been able to achieve returns above the market benchmark through stock selection or market timing strategies. It is a key indicator of an investment manager's skill and is often used in financial models, such as the Capital Asset Pricing Model (CAPM), where it is referred to as "alpha".
Definition: Excess return refers to the portion of an investment's actual return that exceeds a certain benchmark return (such as a market index or risk-free rate). For example, if a stock has an annual return of 10% and the market index has an annual return of 7%, the stock's excess return is 3%. Excess return is often used to evaluate investment performance, particularly in actively managed investment strategies, to determine whether the investment manager can achieve returns higher than the market benchmark through stock selection or market timing strategies. Excess return is a key indicator of an investment manager's ability and is also commonly used in financial models, such as the 'alpha' in the Capital Asset Pricing Model (CAPM).
Origin: The concept of excess return originated from modern portfolio theory and the Capital Asset Pricing Model (CAPM). In the mid-20th century, financial scholars like Harry Markowitz and William Sharpe introduced these theories, emphasizing the relationship between risk and return and introducing the concept of benchmark returns. As financial markets evolved, excess return gradually became an important metric for assessing investment manager performance.
Categories and Characteristics: Excess return can be divided into the following categories:
- Absolute Excess Return: Refers to the portion of investment returns that exceed the risk-free rate. The risk-free rate is typically represented by the yield on government bonds.
- Relative Excess Return: Refers to the portion of investment returns that exceed a market benchmark (such as a stock index). This type of excess return is more commonly used to evaluate actively managed investment strategies.
- Performance Measurement: Excess return is a key indicator for evaluating whether an investment manager can achieve returns higher than the market benchmark through stock selection or market timing strategies.
- Risk Adjustment: When evaluating excess return, it is usually necessary to consider risk-adjusted returns to more accurately reflect the investment manager's ability.
Specific Cases:
- Case 1: A fund manager's fund achieved a 12% return in one year, while the market index returned 8% over the same period. The fund's excess return is 4%. This indicates that the fund manager successfully achieved returns higher than the market benchmark through stock selection or market timing strategies.
- Case 2: An investor purchased a stock that had a 15% return in one year, while the risk-free rate over the same period was 2%. The stock's absolute excess return is 13%. This indicates that the investor achieved significantly higher returns than the risk-free rate by taking on some market risk.
Common Questions:
- How is excess return calculated? The formula for calculating excess return is: Excess Return = Actual Return - Benchmark Return. For example, if an investment's actual return is 10% and the benchmark return is 7%, the excess return is 3%.
- Is excess return always positive? Not necessarily. Excess return can be positive, zero, or negative. If the investment's actual return is lower than the benchmark return, the excess return is negative.
