Extra return: what it is and how it is calculated

Extra return is a key concept in the financial world and is used to refer to the differential between the actual return of a portfolio and that of a risk-free asset or benchmark. This term is synonymous with outperformance or, in English, excess return. The calculation of excess return is critical in evaluating the performance of an investment relative to other options in the market, such as a comparison portfolio or theoretical models such as the Capital Asset Pricing Model (CAPM).

Definition of extra return

Extra return, also known as outperformance or excess return, represents the additional gain earned by an investment relative to a security considered risk-free, such as Treasury bonds, or relative to a benchmark. In practice, it measures how much a portfolio or fund has performed better or worse than a benchmark that could be:

• the risk-free return, such as short-term government bonds;
• the market return, which reflects the average investment performance;
• the return of a benchmark, which is a market index used to compare performance;
• the expected return according to a pricing model, such as the CAPM, which considers systematic risk.

How is extra yield used?

Extra return is a useful tool for investors and fund managers to measure the success of an investment strategy. When a portfolio’s actual return exceeds that of a risk-free asset or benchmark, it is called positive outperformance. Conversely, a negative outperformance indicates that the portfolio has performed below its benchmark.

For example, if a fund earns a return of 7 percent while its benchmark, a market index, returned 5 percent, the outperformance will be 2 percent. This differential is essential to understand whether the fund manager has added value with his investment choices or whether it would have been more cost-effective to invest directly in the benchmark.

Theoretical models to calculate the extra return

One of the most widely used models for measuring extra return is the CAPM (Capital Asset Pricing Model). The CAPM establishes a relationship between an asset’s return and its systematic risk, represented by the beta coefficient. This model makes it possible to calculate the expected return of a portfolio as a function of the risk taken. The extra return in this case will be the difference between the portfolio’s actual return and the expected return determined by the CAPM.

Conclusions

Extra return is an important measure for assessing the effectiveness of an investment by comparing its performance with that of a risk-free asset or benchmark. Through theoretical models such as CAPM, it is possible to calculate the expected return and compare it with the actual return to determine the added value of the investment. This concept is crucial for investors who want to better understand the performance of their portfolios and make informed decisions about their financial future.

This article was created and reviewed by the author with the support of artificial intelligence tools. For more information, please refer to our T&Cs.

This article or page was originally written in Italian and translated English via deepl.com. If you notice a major error in the translation you can write to adessoweb.it@gmail.com to report it. Your contribution will be greatly appreciated