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.

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.

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.

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.