Excess return is simple to understand and doesn’t require any sophisticated statistical knowledge. One calculates excess return using nothing more complicated than subtraction.
One would hope to outperform the benchmark, resulting in an excess return greater than zero. Negative excess return indicates the investor would have been better off investing in a low-cost index product. The higher the excess return, the better.
Excess return does not take into account the level of risk that was undertaken in order to generate the added value.
Also, excess return is frequently confused with alpha. The two are not the same. Alpha first adjusts for market-level risk before calculating manager skill. Excess return does not.
Finally, it is important to utilize an appropriate benchmark when analyzing excess return. Failure to use an appropriate benchmark results in an apples-to- oranges comparison.
Below we see two different ways of displaying the excess return. The upper graph shows the rolling period returns for both the manager in blue and the benchmark in black. The gap between the two is the excess return.
The lower graph is an alternative way of showing the same information. In this case the flat, horizontal line at zero is the benchmark. The blue line represents the difference between the two, i.e. the excess return.
The table below displays the ranges of 10-year excess returns versus the relevant benchmarks across six asset classes. The universes consist of separately managed account composite returns. According to the data, the median manager typically falls short of the benchmark. Of the four equity asset classes, the dispersion between the best and worst large cap fund is the narrowest, even though the size of the large cap universe is the biggest. This suggests that large cap equity is a fairly efficient asset class.
Excess return is one of the simplest metrics to calculate. Its simplicity is both an advantage and a disadvantage. It is easy to understand but does not take into consideration any form of risk.
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