Excess Return: Definition & Formula

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

In this lesson, we will cover the importance of excess returns. Excess returns are returns an investment generates over and above a comparative measure, such as returns on U.S. government securities or industry standard benchmarks.

A Safe Investment

Mary has been thinking a lot about her investments lately. For now she keeps her savings in the safest investment around - U.S. government securities.

Mary started saving when she was young with U.S. savings bonds. But as her savings grew, she moved into Treasury Bills. Treasury Bills (T-Bills) are very short-term investments of one year or less. When Mary puts her money into a T-Bill, she is actually lending it to Uncle Sam. The U.S. government then has an obligation on its books to repay her investment plus the interest!

Because the U.S. government has never missed a principal or interest payment on its debts, the financial community considers treasury securities to be the safest investment in the world. But because they are so safe, they don't need to pay much interest. This means the return on U.S. government securities is very low.

U.S. savings bonds are risk-free investments.
Savings Bond

Calculating Excess Returns

Mary is starting to wonder, though, if Treasury Bills are the best investment. She hears lots of news about the stock market and how the average keeps moving up. She knows the stock market is risky. If the market has a big crash, she can lose lots of money. But she can also get a much higher return than T-Bills when the market is going strong and moving up.

What Mary is interested in is how much excess returns she can get from a riskier investment, such as a mutual fund that invests in common stocks. Excess returns in this case are the returns an investment generates that exceed a risk-free investment, like a T-Bill. Mary notices the Big Blue Mutual Fund had a return of 12% last year. The riskless rate on T-Bills was only 3%, so to calculate the excess returns enjoyed by investors in Big Blue, she uses this formula:

Excess returns = Returns on an investment - Returns on a risk-free investment

The excess returns for Big Blue were 12% - 3%, or 9%. That is also how much Mary missed out on by keeping her money in T-Bills! Now she is going to look at the excess returns on a number of mutual fund investments and do some comparing.

Applying Excess Returns to Benchmarks

Another person who is very interested in excess returns is Brad, the portfolio manager at Big Blue. Brad knows that his fund has to do better than the major market averages, or his clients will move their money to index funds. Index funds seek to match the performance of the major market indexes by investing in a portfolio of the stocks that make up the averages themselves. They have much lower fees than mutual funds because the managers of index funds don't have to make decisions about which stocks to buy.

Brad needs to show his clients that Big Blue can generate excess returns when compared with benchmark averages. When Brad benchmarks, he compares his performance against some widely known industry standard. He uses a simple formula:

Excess returns = Returns on Big Blue - Returns on a benchmark average

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