They are the returns that are attained above and beyond the proxy return.
How Excess Returns Works
Excess returns depend on investment return comparison designated for analysis. Benchmarks and riskless rates with the same risk levels as the analyzed investment are some basic returns. Compared to the other investment alternatives, the investors like to use excess returns as a critical metric for gauging performance. Excess returns are an optimistic hope for all investors.
It is because investors gain more money compared to the investments done elsewhere. To identify excess returns, you need to subtract returns of a single asset from the percentage of total return achieved from another investment. For the calculation of excess returns, you can use measures for multiple returns. Calculating the excess returns can be compared to a benchmark with the same characteristics of return and risk.
The use of closely comparable benchmarks is a return calculation that will result in a return measure that is excess and which is known as alpha. Generally, the return comparisons can either be negative or positive. When there is a positive in excess returns, it means an investment outperformed its comparison. On the other hand, a negative in the excess returns shows an underperformance on the investment.
Excess Return Example
For instance, if the return of treasury for a single year is 2.0% and the Facebook technology stock has 15% in return, then the Facebook investment is an achievement of 13% excess return.
The formula of attaining excess return is asset return - risk-free rate.
For instance, if a stock earns 16% in a year while on the other hand, the treasury bill of USA earned 4%. The stock excess returns will be 16% - 4% = 12%.
Types of Excess Returns
- Riskless rates
- The investors must note that comparing the investment returns and the benchmark results in excess returns. The provided excess returns don’t consider the entire costs of trading. Investors that are seeking capital preservation for different goals are usually using low-risk and riskless investments. The leading example of riskless security is treasuries.
- Depending on the period of maturity, there will be a difference in the expected returns. There are other types of investments that are low risks which include, municipal bonds, certificates of deposits, and money market accounts. Depending on the comparison to risk-free securities, the investors can also determine the levels of excess returns.
- When it comes to determining the excess return, some investors will often want to closely look for a comparable investment. Alpha will come in during this situation. There is a need for a narrowly focus calculation that includes benchmark only with return characteristics and relative risks to investment for alpha attendance. An investor can attain excess returns that are beyond comparable proxy.
- However, the risk is usually associated with the extra return amount. The investment theory determines that the more the investor is willing to risk, the more significantly higher return opportunity. To understand whether the achieved excess returns and returns received are worthwhile, the investors can determine it using some market metrics. Actively managed portfolios and mutual fund critics imply that it is almost impossible to generate alpha for the long term consistently. Due to this, investors should invest in optimized portfolios or stock indexes.