Excess Return (ER)
Excess Return (ER), also known as "alpha" or "abnormal return," is a financial term used to describe the difference between an investment's actual return and its expected return based on its risk profile or benchmark. In other words, excess return measures the performance of an investment or portfolio relative to a benchmark index, market, or another appropriate reference point. A positive excess return indicates that the investment has outperformed its benchmark, while a negative excess return suggests underperformance.
Excess return is commonly used to evaluate the performance of investment managers, mutual funds, or individual stocks. It helps investors determine whether an investment has generated returns beyond what would be expected given its level of risk or exposure to market movements.
Calculating Excess Return:
To calculate the excess return of an investment, you need to compare its actual return to the expected return based on a benchmark or risk factor. The formula for excess return is as follows:
Excess Return (ER) = Actual Return - Expected Return (Benchmark Return)
For example, if an investment has an actual return of 12% and the benchmark return is 10%, the excess return would be:
ER = 12% - 10% = 2%
In this case, the investment has generated a positive excess return of 2%, which means it has outperformed the benchmark by 2%.
Significance of Excess Return:
- Performance evaluation: Excess return is widely used by investors to assess the performance of investment managers, mutual funds, or individual securities. A positive excess return indicates that the investment has generated value beyond what would be expected based on its risk level or benchmark.
- Risk-adjusted performance: Excess return can help investors determine whether an investment has provided adequate returns for the level of risk taken. By comparing excess returns across different investments, investors can identify which investments have provided the best risk-adjusted performance.
- Attribution analysis: Excess return is a key component of performance attribution analysis, which seeks to identify the sources of an investment's outperformance or underperformance relative to a benchmark. This analysis can help investors understand the factors driving a portfolio's performance and make informed decisions about future investments.
It is important to note that excess return is just one measure of investment performance, and it should be used in conjunction with other metrics, such as risk-adjusted performance measures (e.g., Sharpe ratio) and absolute return, to get a comprehensive understanding of an investment's performance.