Loading the player...

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.

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 asset’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. 

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. 

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

    Alpha (α) , used in finance as a measure of performance, is the ...
  2. Portable Alpha

    Portable alpha is a strategy in which portfolio managers separate ...
  3. Risk Measures

    Risk measures give investors an idea of the volatility of a fund ...
  4. Active Risk

    Active risk is a type of risk that a fund or managed portfolio ...
  5. Relative Return

    Relative return is the return an asset achieves over a period ...
  6. Characteristic Line

    A characteristic line is a line formed using regression analysis ...
Related Articles
  1. Investing

    Alpha and beta for beginners

    Alpha and beta are both risk ratios that investors use as a tool to calculate, compare and predict returns. Here is an in-depth look at what alpha and beta are and what they measure.
  2. Investing

    5 ways to measure mutual fund risk

    Statistical measures such as alpha and beta can help investors understand investment risk on mutual funds and how it relates to returns.
  3. Trading

    Bettering your portfolio with alpha and beta

    Increase your returns by creating the right balance of both these risk measures.
  4. Investing

    Understanding Volatility Measurements

    Learn how to choose a fund with an optimal risk-reward combination. Find more information about standard deviation, beta, and more.
  5. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk.
  6. Financial Advisor

    Measure Your Portfolio's Performance

    Measuring the success of your investment solely on the portfolio return may leave you blindsided to risk. Learn how to evaluate your investment return.
  7. Investing

    Smart Beta Strategies for Retail Investors

    Retail investors must understand the processes underlying the various “smart-beta” investment strategies, and build portfolios that are low-cost, diversified, and aligned with their goals.
  8. Investing

    Adding Alpha Without Adding Risk

    Learn how to generate higher returns in your portfolio while keeping the same risk profile.
RELATED FAQS
  1. 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 >>
  2. Is negative alpha a signal to sell an investment?

    Learn how alpha is used to assess an investment's profitability relative to the broader market and why a negative value isn't ... 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 >>
  4. How does market risk affect the cost of capital?

    Find out how market risk directly affects the total cost of capital, including how to use the capital asset pricing model ... Read Answer >>
  5. What's the relationship between R-squared and beta?

    Learn about the relationship between R-squared and beta. Explore how the concepts are related and often used in conjunction ... Read Answer >>
Trading Center