EXCESS RETURN

This is the also known as ‘Alpha’ or abnormal rate of return which is not explained by the overall markets rate of return. The excess return is widely used because it is generated by the talent and skill of either the direct investor or the portfolio manager. How it works…

A portfolio manager is expecting a 10% return next year and after the year passes and the actual returns are 15% the basic calculation for excess return is 15% minus 10% = 5%. In mathematical terms, excess return is simply the rate of return that exceeds what was expected. It goes without saying that institutions will use models to predict future growth and a commonly used formula is capital asset pricing model (CAPM).

CAPM calculation

R = Rf + beta (Rm – Rf) + excess return

R – security’s or portfolios return

Rf – risk free rate of return (An asset with no risk, based on a guaranteed return)

Beta – price volatility relative to overall market

Rm – market return

The CAPM formula is used to ascertain what the rate of return on a certain security or portfolio should be within certain market conditions. Whilst excess return is somewhat controversial it does have a knack for separating skill from luck when comparing performance when investing.

Another aspect of portfolio managers and investors is that they need to calculate risk as well as performance. A common mistake is to invest and only think about returns and not the risk associated to make returns. In the next part, we are going to look at some common risk/performance based methods. Traditionally investors couldn’t measure risk and performance in a single way but in modern times with both technology and statistics this has become possible.