Excess Return

Definition

Excess return refers to the return of an investment above the risk-free rate or the benchmark return. It is a critical concept in evaluating investment performance, helping to assess whether an investment has generated additional returns due to risk-taking or skill. This measure is often used in performance evaluation to determine how well an investment has performed compared to a standard or expected return, allowing investors to make informed decisions about asset allocation and portfolio management.

5 Must Know Facts For Your Next Test

1. Excess return can be calculated as the difference between an investment's actual return and the risk-free rate, highlighting additional gains achieved from riskier assets.
2. Investors often use excess return as a key indicator of a fund manager's skill in generating returns beyond what would be expected based on market movements.
3. A positive excess return indicates that an investment has outperformed its benchmark, while a negative excess return suggests underperformance.
4. The measurement of excess return is crucial for portfolio managers as it assists in making comparisons across different asset classes and investment strategies.
5. Excess return is commonly utilized in performance evaluation metrics such as the Sharpe Ratio, which emphasizes the importance of considering both returns and volatility.

Review Questions

• How does excess return assist investors in evaluating the performance of their investments?
  • Excess return helps investors determine if their investments are providing returns that surpass the risk-free rate or benchmark returns. By comparing actual returns to these standards, investors can assess whether they are being adequately compensated for the risks taken. This evaluation is essential in understanding the effectiveness of different investment strategies and identifying skilled fund managers who can deliver superior performance.
• Discuss the relationship between excess return and risk management in portfolio construction.
  • In portfolio construction, excess return is closely tied to risk management as it provides insight into how much additional return an investor is receiving for taking on extra risk. A well-constructed portfolio seeks to maximize excess returns while managing exposure to risk factors. By evaluating investments based on their excess returns, portfolio managers can adjust allocations to optimize overall portfolio performance while controlling for volatility and potential losses.
• Evaluate the implications of consistent positive excess returns for an investor's long-term strategy and market behavior.
  • Consistent positive excess returns indicate that an investor or fund manager is successfully outperforming benchmarks and managing risks effectively over time. This track record can lead to increased confidence among investors, encouraging them to allocate more capital to those strategies or funds. Additionally, when numerous investors chase these superior returns, it may result in market distortions and shifts in asset prices, influencing overall market behavior and creating cycles of performance persistence that impact future investment opportunities.

Related terms

Risk-Free Rate: The theoretical return on an investment with zero risk, often represented by government bonds such as U.S. Treasury bills.

Benchmark Return: A standard or point of reference against which the performance of an investment or portfolio can be measured, commonly represented by indices like the S&P 500.

Sharpe Ratio:

A measure used to evaluate the risk-adjusted return of an investment, calculated by dividing the excess return of the investment by its standard deviation.