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Active adjusted return

What Is Active Adjusted Return?

Active adjusted return is a metric used in portfolio management to evaluate the true profitability of an investment strategy after accounting for various factors that can influence raw returns, such as fees, trading costs, and the level of risk taken. This measure falls under the broader discipline of portfolio performance measurement, aiming to provide a clearer picture of a fund manager's skill in generating returns above a chosen benchmark index. While standard active return simply subtracts the benchmark's return from the portfolio's return, active adjusted return incorporates additional "adjustments" to reflect the actual value added (or subtracted) from an investor's perspective, especially after all expenses and risks are considered. This comprehensive approach helps investors and analysts assess the efficiency and effectiveness of active management.

History and Origin

The concept of evaluating investment performance beyond simple gross returns gained prominence with the rise of modern portfolio theory and the increasing complexity of financial markets. Early measures of active performance often focused solely on the difference between a portfolio's return and its benchmark. However, as the investment landscape evolved, it became clear that such a basic comparison could be misleading. Fees and trading costs, for instance, directly reduce an investor's net return. The recognition that higher returns might simply be due to taking on more risk, rather than superior skill, led to the development of risk-adjusted return metrics.

The formalization of "adjusted" returns, particularly in the context of active management, has been influenced by regulatory bodies and academic research. For example, the Securities and Exchange Commission (SEC) has clear guidelines requiring investment advisers to present net performance alongside gross performance in advertisements to ensure investors understand the impact of fees on their returns.4 This regulatory emphasis reinforces the importance of considering all costs when evaluating an investment. The ongoing debate between active and passive investing also highlights the need for sophisticated metrics like active adjusted return to truly ascertain if active strategies justify their typically higher costs.

Key Takeaways

  • Active adjusted return provides a more realistic assessment of an investment portfolio's performance by considering factors beyond just the difference from a benchmark.
  • Key adjustments often include subtracting fees, trading costs, and accounting for the level of investment risk.
  • This metric is crucial for determining if an active investment strategy truly adds value for the investor after all expenses and risks are factored in.
  • A positive active adjusted return suggests a fund manager has demonstrated skill in generating excess returns efficiently.
  • It serves as an essential tool for investors performing due diligence on actively managed funds.

Formula and Calculation

The fundamental calculation of active return is straightforward:

Active Return=Portfolio Return−Benchmark Return\text{Active Return} = \text{Portfolio Return} - \text{Benchmark Return}

However, to arrive at the Active Adjusted Return, this basic formula is refined to include deductions for expenses and potential adjustments for risk. While there isn't one universally standardized formula for "active adjusted return" as it can vary based on the specific adjustments made, a common conceptual approach involves:

Active Adjusted Return=(Portfolio Return−Fees and Expenses)−(Benchmark Return+Risk Adjustment)\text{Active Adjusted Return} = (\text{Portfolio Return} - \text{Fees and Expenses}) - (\text{Benchmark Return} + \text{Risk Adjustment})

Where:

  • Portfolio Return: The total return generated by the investment portfolio over a specific period.
  • Fees and Expenses: This includes the expense ratio, trading costs, management fees, performance fees, and any other charges incurred by the fund.
  • Benchmark Return: The total return of the designated benchmark index against which the portfolio's performance is measured.
  • Risk Adjustment: A component that modifies the benchmark return (or the active return itself) to account for differences in systematic risk or other risk factors between the portfolio and its benchmark. This might involve models like the Capital Asset Pricing Model (CAPM) to derive an expected return given the portfolio's beta, or more complex multi-factor models.

For example, if the adjustment focuses solely on fees, the adjusted active return would simply be the active return minus the fees. If it's risk-adjusted, measures like Alpha or the Information Ratio are often implicitly or explicitly calculating a form of adjusted active return.

Interpreting the Active Adjusted Return

Interpreting active adjusted return involves assessing whether an active management strategy has genuinely added value beyond what a passive investment in the benchmark would have achieved, considering all costs and risks. A positive active adjusted return indicates that the portfolio manager has successfully generated excess returns after covering their operational costs and without simply taking on disproportionately higher levels of risk. This is the goal of active investors: to outperform the market net of all influencing factors.

Conversely, a negative active adjusted return suggests that the active strategy failed to compensate for its costs or the risks undertaken. In such cases, investors would have been better off investing in a low-cost passive fund tracking the benchmark. When evaluating this metric, it is important to consider the investment's investment objectives and the prevailing market conditions, as a fund's ability to achieve a positive active adjusted return can fluctuate.

Hypothetical Example

Consider two hypothetical mutual funds, Fund A and Fund B, both aiming to outperform the S&P 500 Index. Over a year, the S&P 500 (our benchmark) returns 10%.

Fund A:

  • Gross Portfolio Return: 12.0%
  • Expense Ratio: 1.0%
  • Trading Costs (estimated): 0.5%
  • Net Portfolio Return = 12.0% - 1.0% - 0.5% = 10.5%

Active Return (before adjustments) for Fund A = 12.0% (Portfolio Gross Return) - 10.0% (Benchmark Return) = 2.0%.

To calculate Active Adjusted Return for Fund A, we subtract the total costs from the active return:
Active Adjusted Return (Fund A) = 2.0% (Active Return) - 1.0% (Expense Ratio) - 0.5% (Trading Costs) = 0.5%.
In this case, Fund A's active adjusted return is 0.5%, indicating it provided a small positive excess return after accounting for all its operational costs relative to the benchmark.

Fund B:

  • Gross Portfolio Return: 11.5%
  • Expense Ratio: 1.5%
  • Trading Costs (estimated): 0.7%
  • Net Portfolio Return = 11.5% - 1.5% - 0.7% = 9.3%

Active Return (before adjustments) for Fund B = 11.5% (Portfolio Gross Return) - 10.0% (Benchmark Return) = 1.5%.

To calculate Active Adjusted Return for Fund B:
Active Adjusted Return (Fund B) = 1.5% (Active Return) - 1.5% (Expense Ratio) - 0.7% (Trading Costs) = -0.7%.
Fund B has a negative active adjusted return of -0.7%, meaning that while it had a positive active return before costs, the high fees and trading costs eroded all of that excess, leading to underperformance compared to simply investing in the benchmark. This example highlights why active adjusted return is a critical measure for investors to evaluate true outperformance.

Practical Applications

Active adjusted return is a vital metric in several areas of the investment world. For investors, it serves as a robust tool for evaluating the efficacy of active management and making informed allocation decisions. It helps in distinguishing genuine outperformance driven by skill from returns that are merely a result of higher risk exposure or are entirely consumed by fees.

Investment analysts frequently use active adjusted return in performance attribution studies to break down the sources of a fund's returns. By isolating the impact of fees and risk, they can better understand where value is being added or destroyed. This is particularly relevant given the regulatory requirements for transparent performance reporting. According to the SEC's marketing rule, investment advisers must present net performance alongside gross performance in advertisements, calculated over the same time period and with equal prominence.3 This underscores the importance of a clear, adjusted view of returns for investor protection.

Furthermore, consultants advising institutional clients, such as pension funds or endowments, rely on active adjusted return to evaluate potential fund managers. For example, firms like Vanguard, known for their low-cost approach, even apply this philosophy to their active funds, demonstrating that managing fees is a critical component of delivering strong active adjusted returns.2 Even within diversification strategies, assessing the adjusted return of different components can provide deeper insights into their true contribution to the overall portfolio's success.

Limitations and Criticisms

While active adjusted return offers a more nuanced view of performance, it is not without limitations or criticisms. One primary challenge lies in the subjectivity of the "adjustment" factors, particularly regarding risk. While some adjustments, like fees, are quantifiable, determining the precise impact of various risk factors can be complex and depends on the specific risk model or methodology employed. Different models, such as the Capital Asset Pricing Model (CAPM) or multi-factor models, can lead to different risk adjustments and, consequently, different active adjusted return figures.

Another criticism centers on the difficulty in consistently achieving positive active adjusted returns. Research by firms such as Morningstar suggests that, after accounting for fees, many actively managed funds fail to consistently outperform their benchmarks.1 This highlights the challenge active managers face in generating enough gross alpha to overcome their operating costs. The very act of trading to achieve active returns incurs transaction costs, which directly erode net performance.

Moreover, the retrospective nature of performance measurement means that a strong past active adjusted return does not guarantee future results, as market conditions and manager skill can change. This metric should be used as part of a holistic evaluation, considering a manager's investment process, philosophy, and consistency, rather than as a sole predictor of future success.

Active Adjusted Return vs. Active Return

The key distinction between active adjusted return and active return lies in the depth of analysis and the factors considered. Active return, also known as "excess return" or "relative return," is simply the difference between a portfolio's gross return and its benchmark index's return over a specified period. It provides a quick, top-line indication of whether a portfolio outperformed or underperformed its benchmark.

In contrast, active adjusted return takes this calculation a significant step further by incorporating additional adjustments, most notably for fees and various forms of risk. The purpose of these adjustments is to provide a more accurate representation of the net value added by the active manager. An active return of 2% might seem good, but if the fund's expense ratio and trading costs combine to 2.5%, the active adjusted return would be -0.5%, indicating that the manager's outperformance was completely consumed by costs. Furthermore, if that 2% active return was achieved by taking on significantly more market risk than the benchmark, a risk adjustment would penalize the return, resulting in a lower active adjusted return. While active return tells you if you beat the benchmark, active adjusted return tells you how efficiently and profitably you did so after accounting for the full cost and risk picture.

FAQs

What does "adjusted" mean in active adjusted return?

"Adjusted" means that the raw active return is modified to account for other factors that impact the investor's actual profit, primarily investment fees and the level of investment risk taken. This provides a more realistic measure of a portfolio manager's skill.

Why is it important to consider fees and expenses in active adjusted return?

Fees and expenses, such as management fees, administration costs, and trading costs, directly reduce the net return an investor receives. By including them in the calculation, active adjusted return shows whether the active manager's gross outperformance was significant enough to justify these costs and still provide a benefit over a passive investment.

How does risk factor into active adjusted return?

Risk is incorporated by attempting to normalize the return for the level of risk assumed. If a manager achieves higher returns by simply taking on substantially more risk than the benchmark, that outperformance may not be due to skill but rather increased risk exposure. Risk adjustments, often using measures like beta or tracking error, aim to isolate the returns attributable to management skill.

Is active adjusted return the same as alpha?

Not exactly, but they are closely related. Alpha is a specific type of risk-adjusted return that measures a portfolio's performance relative to its expected return, given its beta (systematic risk) and the market's return. Active adjusted return is a broader concept that can encompass alpha, along with explicit adjustments for fees and other costs, providing a more comprehensive "net-net" view of an active manager's performance.

Can a fund have a positive active return but a negative active adjusted return?

Yes, this is entirely possible and highlights the importance of the "adjusted" component. A fund might generate returns above its benchmark (positive active return), but if its fees and trading costs are too high, or if it took on excessive uncompensated risk, the active adjusted return could turn negative, meaning investors would have been better off in a lower-cost, passive alternative.