## What are 'Excess Returns'

Excess returns are investment returns from a security or portfolio that exceed the riskless rate on a security generally perceived to be risk free, such as a certificate of deposit or a government-issued bond. Additionally, the concept of excess returns may also be applied to returns that exceed a particular benchmark, or index with a similar level of risk.

Next Up

## BREAKING DOWN 'Excess Returns'

Determining the excess returns requires the subtracting of the riskless rate, or benchmark rate, from the actual rate achieved. For example, if the current riskless rate is 1.2% and the portfolio being examined received a return of 8%, the excess return would be the 6.8% difference. Excess returns can be either positive or negative depending on the result of the equation. Positive excess returns demonstrate the investment outperformed the riskless rate or benchmark, while negative excess returns occur when an investment underperforms in comparison to the riskless rate or benchmark.

Widely used as a measure of the value added by the portfolio or investment manager, or the manager's ability to beat the market, excess returns may also be referred to as the alpha after being adjusted by the risk assessed, known as the beta.

## Definition of Alpha and Beta

The alpha and beta are both metrics relating to the level of risk or volatility experienced in a particular security. While the alpha provides a measurement in regards to the asset's performance, the beta specifies the level of risk present when compared to the capital asset pricing model (CAPM). Calculated using a form of regression analysis, the beta is a measure of the assetâ€™s ability to respond to market fluctuations.

For example, consider a large-cap U.S. mutual fund that has the same level of risk (i.e. beta = 1) as the S&P 500 index. If the fund generates a return of 12% in a year when the S&P 500 has only advanced 7%, the difference of 5% would be considered as excess return, or the alpha generated by the fund manager.

## Excess Returns and Long-Term Results

Critics of mutual funds and other actively managed portfolios contend that it is next to impossible to generate excess returns on a consistent basis over the long term, as a result of which, most fund managers underperform the benchmark index over time. Additionally, active funds often come with higher fees that can negate a portion of the gains experienced by the investor.Â

Detractors of the concept of alpha also generally adhere to the efficient market hypothesis (EMH), which states that the market tends to price in all available information. Therefore, active managers cannot have special information that allows them to strategize to beat the market. For this reason, they attribute most of fund managers' excess returns to luck rather than skill.Â

This has led to the tremendous popularity of index funds and exchange-traded funds (ETF), and has resulted in some fund management companies, such as Legg Mason, offering additional hybrid products. The new offerings are designed to attract investors who were inclined to pull their funds out of managed funds and investing those funds into various index funds.

RELATED TERMS
1. ### Alpha Generator

An alpha generator is any security that, when added to an existing ...
2. ### Portable Alpha

Portable alpha is a strategy in which portfolio managers separate ...
3. ### Jensen's Measure

Jensen's measure, or "Jensen's alpha," indicates the portion ...
4. ### Risk Measures

Risk measures give investors an idea of the volatility of a fund ...
5. ### Beta

Beta is a measure of the volatility, or systematic risk, of a ...
6. ### Dispersion

A statistical term describing the size of the range of values ...
Related Articles

2. Investing

### The Capital Asset Pricing Model: an Overview

CAPM helps you determine what return you deserve for putting your money at risk.
3. Investing

4. Investing

### How to Use a Benchmark to Evaluate a Portfolio

What is an investment benchmark and how is it used to evaluate the risk and return in a portfolio.
5. Investing

### Beta: Know the Risk

Beta says something about measuring price risk in stocks, but how much does it say about fundamental risk factors too?
6. Investing

### Overview of 3 Global Equity Mutual Funds (MWEFX,MSFBX)

Discover three global equity mutual Funds that perform well in both bull and bear markets, complete with a summary of investment goals and performance.
7. Investing

### USMV vs. FVD: Comparing Smart Beta Funds

A comparison between two smart beta ETFs, the iShares MSCI USA Minimum Volatility ETF and the First Trust Value Line Dividend Index Fund.
RELATED FAQS

2. ### What's the difference between alpha and beta?

Alpha is a measurement of a portfolio manager's performance in relation to the overall market. Beta gauges the volatility ... Read Answer >>
3. ### How does beta measure a stock's market risk?

Learn how beta is used to measure risk versus the stock market, and understand how it is calculated and used in the capital ... Read Answer >>

Hot Definitions
1. ### Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
2. ### Financial Risk

Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
3. ### Enterprise Value (EV)

Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
4. ### Relative Strength Index - RSI

Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
5. ### Dividend

A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
6. ### Inventory Turnover

Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.