Excess return, also known as alpha, is a measure of how much a fund has under or outperformed the benchmark against which it is compared. It can be calculated under the capital asset pricing model (CAPM).
This important financial return metric allows investors to compare sets of funds against each other, in order to see which fund has generated greater excess returns. Of course, there are a number of other measures of performance and so while one investor may favour a fund with high excess returns, others may view the same strategy as too risky.
By using excess return (alpha) and volatility risk (as described by beta), investors can evaluate a fund’s total performance on a risk-adjusted basis.
Excess return can be positive (denoting outperformance relative to the benchmark) or negative (indicating underperformance). It is a measure of the portion of a fund’s return which is not explained by overall market returns. As such, an excess return analysis can help determine whether outperformance is the result of a portfolio manager’s skill, or simply the result of movements in stock markets. Similarly for alternative indices, excess return can gauge the quality of the index’s strategy and underlying stock-selection rules.
Indices are compared to market benchmarks such as the S&P 500, which tracks large US stocks and is seen as a barometer for the market as a whole. For that reason, a fund with a beta of near 1 (which indicates broad market exposure and volatility in line with the upward and downward movements of the benchmark) might produce slightly negative excess returns. This is because total return includes fund expenses, so a performance similar to the benchmark would yield a slightly negative alpha after taking fees into account.
Calculating excess returns:
CAPM, which calculates expected total return, can be reconstructed to show excess return:
Excess return = RF + β(MR – RF) – TR
Where:
RF = risk-free rate of return (usually based on government bonds)
β = the fund’s beta value
MR = return generated from the market
TR = total return from the investment
The search for excess returns is yielding new products
Partly on the back of volatile and risky global markets, the constant hunt for sources of excess return is behind the proliferation of new strategies, products and investment techniques. An offshoot of this is the rise of quantitative investing, which seeks to analyse data within a set of rules in order to identify market abnormalities and stock characteristics which offer the best risk-adjusted returns.
And since many strategies are short term in nature, the quant business needs to continually adapt and innovate in order to find the next source of alpha, thereby driving the development of the entire investment industry.
The result: investors have more options than ever before and the trend is ongoing.
Within the world of quant-based smart beta indices alone, the number of products and strategy types is exploding. ETF management company BlackRock expects the global value of smart beta ETF assets will balloon from US$282bn currently to $1 trillion in 2020, and $2.4 trillion in 2025.
Smart beta funds use alternative index construction and weighting methods compared to traditional, size-based indices (such as the benchmark S&P 500 Index). The aim is to take advantage of market anomalies and underlying risk factors in order to boost returns and manage risk.
Underlying risk characteristics carry a risk premium, which is the source of excess returns.
The days of excess returns coming to an end?
Some theorists argue that factor strategies will become victims of their own success. With capital pouring into identified financial market anomalies (or factors) such as value stocks (which are cheap relative to their intrinsic value), the attractiveness of these investments will eventually be ironed out and the market will tend towards equilibrium. In other words, sources of excess returns (or risk factors which have not yet been fully exploited) will in the long run be exhausted.
However, quant strategies target superior returns on a risk-adjusted basis, meaning they will still have important roles to play in balanced portfolios. Further, the excess return benefits of these strategies are a long way off being bled dry – if that point in time does eventually materialise.
In today’s uncertain and volatile market environment, sources of excess return (alpha) appear frequently as investors misprice securities, particularly when over- or under-reacting to news.
