Excess return is the profit an investment generates that surpasses the performance of a specific benchmark or a risk-free rate.
Understanding excess return
When Elephants evaluate their portfolios, they compare their actual gains against a baseline. This baseline is often a broad market index, like the MSCI World Index, or a risk-free rate. A risk-free rate is the theoretical return of an investment with zero risk, usually represented by stable government debt such as German Bunds, UK Gilts, or Japanese Government Bonds. The difference between the actual return of the asset and this baseline is the excess return.
Fund managers and individual investors use this calculation to determine if a specific investment strategy adds value. If an actively managed fund charges high fees but produces returns identical to a low-cost index tracker, the excess return is zero. Investors calculate excess return to see if the active decisions made by a manager resulted in higher profits than simply holding the market average.
Excess return is related to alpha, though the two terms have specific mathematical differences. Excess return is a straightforward subtraction of the benchmark return from the investment return. Alpha is a risk-adjusted measure that accounts for the volatility of the investment relative to the market. Both concepts attempt to quantify performance beyond standard market movements.
Evaluating excess return requires selecting an appropriate benchmark. An investor holding a portfolio of emerging market equities must compare their returns against an emerging market index. Comparing high-risk emerging market stocks to a low-risk government bond yield produces a large excess return figure, but it fails to account for the substantial difference in risk between the two asset classes.
Example
An Elephant decides to invest 10,000 euros in a global peanut distribution company. After one year, the value of the investment grows to 10,800 euros, representing an 8% return. During that same year, the broader global agricultural equity index – the benchmark chosen for this investment – returns 5%. The local government bond yield, representing the risk-free rate, is 2%.
To find the excess return over the benchmark, the Elephant subtracts the 5% index return from the 8% investment return, resulting in an excess return of 3%. If the Elephant wants to measure the excess return against the risk-free rate, they subtract the 2% bond yield from the 8% investment return, yielding an excess return of 6%. These figures show the Elephant exactly how much additional profit the peanut company generated compared to the alternative baseline options.