Excess return

An excess return may be:

  • the amount by which the return on an investment is greater than the risk free rate of return over a period, or,
  • The amount by which the return on an investment is greater than the return on its benchmark index.

The first of these is not the same as the abnormal return, which is the out-performance over the risk adjusted return.

The excess return is closely related to the risk premium: the risk premium implied by the market price of a security is the expected value of the excess return.

A positive excess return is not always a good thing: it can often imply that the level of risk of a portfolio is greater than it should be. A good example is this is a high tracking error caused by an index tracker outperforming the index.

Conversely a low excess return may be a sign that a portfolio has been run conservatively. This may mean it needs to be compared to a different benchmark, such as a style index — or that it needs to be run differently.

Of course, a high or significantly negative excess return may be simply the result of bad stock picking or even just bad luck. The portfolio manager would no doubt prefer the last explanation.

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