What Are Excess Returns?
Let me explain excess returns directly: they're the returns you get from an investment that go above and beyond what a benchmark like the stock market provides. They rely on a specific comparison for analysis, and common ones include the risk-free rate or benchmarks that match the risk level of your investment.
Key Takeaways
- Excess returns depend on a designated investment return comparison for analysis.
- The riskless rate and benchmarks with similar levels of risk to the investment being analyzed are commonly used in calculating excess return.
- Alpha is a type of excess return metric that focuses on performance return in excess of a closely comparable benchmark.
- Excess return is an important consideration when using modern portfolio theory which seeks to invest with an optimized portfolio.
Understanding Excess Returns
You should know that excess returns are a key metric for gauging how your investment performs against alternatives. Generally, you want positive excess returns because they mean more money than you'd get elsewhere.
To identify excess returns, subtract one investment's return from another's total return percentage. You can use various measures; some compare to a risk-free rate, while others use a benchmark with similar risk, which gives you alpha.
Returns can be positive or negative—positive means outperformance, negative means underperformance. Remember, comparing to a benchmark like the S&P 500 doesn't always account for trading costs or fees in a managed fund.
Excess Return vs. Riskless Rates
Riskless investments like U.S. Treasuries help preserve capital, with maturities from one month to 30 years, each with yields along the Treasury curve. Low-risk options include CDs, money market accounts, and municipal bonds.
You can calculate excess returns by comparing to these risk-free securities. For instance, if a one-year Treasury returns 2.0% and Meta stock returns 15%, your excess return from Meta is 13%.
Alpha
When you need a closer comparison, alpha comes into play—it's excess return calculated against a benchmark with matching risk and return traits. Fund managers often aim for alpha over their benchmark.
For broad stocks, compare to the S&P 500 or Russell 3000; for sectors like large-cap tech, use the Nasdaq 100. Active managers seek alpha, while passive ones match the index.
If a large-cap mutual fund returns 12% when the S&P 500 returns 7%, that's 5% alpha from the manager.
Excess Return vs. Risk Concepts
Excess returns tie closely to risk—the more risk you take, the higher potential for returns, per investment theory. Metrics like beta help you see if your returns are worth it.
Beta
Beta measures an investment's volatility against the market, usually the S&P 500. A beta of 1 means it moves with the market; above 1 means more volatility and potential gains or losses; below 1 means less.
It's used in the Capital Asset Pricing Model: Ra = Rrf + β × (Rm − Rrf), where Ra is expected return, Rrf is risk-free rate, Rm is market return, and β is beta. Treasuries have beta near zero, while Meta's is about 1.29, amplifying market moves.
Jensen’s Alpha
In active management, Jensen's alpha shows how much excess return relates to risks beyond the benchmark. Calculate it as: Jensen’s Alpha = Ri − (Rf + β(Rm − Rf)), where Ri is portfolio return, Rf is risk-free, β is beta, Rm is market return.
Zero means the alpha matched the risk; positive means overcompensation, negative means under.
Sharpe Ratio
The Sharpe ratio helps you understand excess return per risk unit: Sharpe Ratio = (Rp − Rf) / Portfolio Standard Deviation, with Rp as portfolio return and Rf as risk-free.
Higher ratios mean more return per risk. Compare funds with 15% returns—if one has Sharpe 2 and another 1, the first is better at generating return per risk.
Special Considerations
Critics say generating alpha consistently long-term is nearly impossible, so you're often better with index funds or optimized portfolios for expected returns plus excess over risk-free.
This supports diversified, risk-optimized portfolios. The Efficient Frontier plots returns and risks from CAPM, with the Capital Market Line touching the optimal point.
You can choose along this line based on risk preference—zero risk means all in risk-free; full risk means the market portfolio, with excess return as the difference from risk-free.
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