Excess Returns
Excess returns are returns achieved above and beyond the return of a proxy. Excess returns will depend on a designated investment return comparison for analysis. Some of the most basic return comparisons include a riskless rate and benchmarks with similar levels of risk to the investment being analyzed.
Definition: Excess return refers to the additional return that exceeds a certain benchmark return. Excess return depends on the specified investment return comparison used for analysis. Some of the most basic return comparisons include the risk-free rate and benchmarks with similar risk levels to the analyzed investment.
Origin: The concept of excess return originated from Modern Portfolio Theory (MPT), proposed by Harry Markowitz in the 1950s. MPT emphasizes optimizing the balance of returns and risks through diversification. The concept of excess return was further developed in the Capital Asset Pricing Model (CAPM), introduced by William Sharpe in the 1960s.
Categories and Characteristics: Excess return can be divided into two categories: absolute excess return and relative excess return. Absolute excess return refers to the portion of investment return that exceeds the risk-free rate; relative excess return refers to the portion of investment return that exceeds a market benchmark (e.g., S&P 500 index). Absolute excess return is typically used to evaluate the overall performance of an investment, while relative excess return is used to compare the performance of an investment against a market benchmark.
Specific Cases: Case 1: Suppose an investor achieves a 10% return in one year, while the risk-free rate during the same period is 2%. The investor's absolute excess return is 8%. Case 2: A fund achieves a 12% return in one year, while the S&P 500 index returns 9% during the same period. The fund's relative excess return is 3%.
Common Questions: 1. Why is excess return important? Excess return is a crucial metric for evaluating investment performance, helping investors assess the effectiveness of their investment strategies. 2. How to calculate excess return? Excess return = Investment return rate - Benchmark return rate. 3. Does excess return guarantee future performance? No, excess return only reflects past performance, and future investment returns remain uncertain.
