Active return

What Is Active Return?

Active return represents the difference between the actual return of an actively managed investment portfolio and the return of its chosen benchmark index. It is a core concept within portfolio management, specifically in the realm of performance evaluation. When a portfolio generates an active return, it signifies the extent to which a fund manager's decisions, such as security selection and asset allocation, have added value beyond simply tracking a market or sector. A positive active return indicates outperformance, while a negative active return suggests underperformance relative to the benchmark.

History and Origin

The concept of active return gained prominence with the rise of modern portfolio theory and the increasing scrutiny of investment performance. As mutual funds and other professionally managed accounts became more widespread, investors sought ways to evaluate whether the fees associated with active management were justified by superior returns. Early academic work in finance began to dissect portfolio performance, separating the returns attributable to broad market movements from those generated by the manager's specific investment decisions. Research has explored the critical role that active management plays in fostering efficient markets by counteracting investor biases and aiding the incorporation of new information into prices.¹³

Key Takeaways

• Active return measures the value added or subtracted by an investment manager's decisions compared to a benchmark.
• It is a key metric for evaluating the effectiveness of an investment strategy.
• A positive active return indicates outperformance, while a negative active return means underperformance.
• Active return is often considered alongside other metrics like tracking error and the Information ratio for a comprehensive performance assessment.
• Factors such as management fees and trading costs directly impact net active return.

Formula and Calculation

The calculation of active return is straightforward, representing the excess return over a benchmark.

The formula for active return is:

Where:

• Portfolio Return: The total return generated by the actively managed investment portfolio over a specific period.
• Benchmark Return: The total return of the chosen benchmark index over the same period.

For example, if a portfolio generates a return of 12% in a year, and its benchmark index returns 10% over the same period, the active return would be 2%. This 2% represents the value added by the fund manager beyond merely replicating the benchmark.

Interpreting the Active Return

Interpreting active return involves understanding its implications for a portfolio's performance and the skill of its manager. A consistently positive active return suggests that the fund manager possesses skill in security selection, market timing, or asset allocation. However, a single period of positive active return does not definitively prove skill, as random fluctuations can also contribute to outperformance.

Investors should consider the magnitude and consistency of active return over various market cycles. A manager generating a modest but consistent positive active return over several years, particularly through different economic conditions, may be demonstrating true skill. Conversely, a high but volatile active return might indicate a higher level of risk-taking rather than consistent skill. It is crucial to evaluate active return in conjunction with risk-adjusted return measures and performance attribution to understand the sources of the excess return.

Hypothetical Example

Consider an investment portfolio managed actively, aiming to outperform the S&P 500 Index.

Scenario:

• Beginning Portfolio Value: $1,000,000
• Ending Portfolio Value: $1,120,000 (after all fees and expenses)
• S&P 500 Index Beginning Value: 4,000 points
• S&P 500 Index Ending Value: 4,360 points

Calculation:

1. Portfolio Return:
   (\text{Portfolio Return} = \frac{(\text{Ending Value} - \text{Beginning Value})}{\text{Beginning Value}} = \frac{($1,120,000 - $1,000,000)}{$1,000,000} = \frac{$120,000}{$1,000,000} = 0.12 \text{ or } 12%)
2. Benchmark Return:
   (\text{Benchmark Return} = \frac{(\text{Ending Index Value} - \text{Beginning Index Value})}{\text{Beginning Index Value}} = \frac{(4,360 - 4,000)}{4,000} = \frac{360}{4,000} = 0.09 \text{ or } 9%)
3. Active Return:
   (\text{Active Return} = \text{Portfolio Return} - \text{Benchmark Return} = 12% - 9% = 3%)

In this hypothetical example, the portfolio generated an active return of 3%. This indicates that the active management decisions contributed 3% in additional return beyond what a passive investment in the S&P 500 Index would have yielded. This excess return is often referred to as alpha.

Practical Applications

Active return is a vital metric across various areas of finance:

• Investment Manager Selection: Institutional investors and wealth managers utilize active return to screen and select fund managers. A consistent track record of positive active return is a primary indicator of a manager's potential to add value. This helps in identifying managers whose investment strategy aligns with the investor's objectives.
• Performance Review: For existing portfolios, active return is regularly analyzed to assess whether the manager is meeting their mandate and justifying their fees. This review often involves detailed performance attribution to understand the specific drivers of active return, such as sector allocation or stock picking.
• Regulatory Compliance: Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), have rules regarding how investment performance, including active return, can be advertised to the public. The SEC's marketing rule requires investment advisers to present performance information clearly and fairly, often mandating the presentation of both gross and net performance to avoid misleading investors about the impact of fees.¹²,¹¹
• Research and Analysis: Academics and financial analysts study active return to understand trends in market efficiency and the efficacy of active management strategies. Reports like the Morningstar Active/Passive Barometer regularly evaluate the performance of active funds against their passive counterparts across various categories.¹⁰,⁹,⁸

Limitations and Criticisms

Despite its utility, active return has several limitations and faces criticism:

• Reliance on Benchmark Selection: The choice of benchmark index significantly impacts the calculated active return. An inappropriate benchmark may make a manager's performance appear better or worse than it truly is. A manager might generate a positive active return simply because their chosen benchmark does not accurately reflect their true investment universe or risk profile.
• Impact of Fees and Expenses: While active return measures outperformance before fees, investors ultimately receive net active return, which is the return after deducting all costs, including the expense ratio and trading costs. High fees can significantly erode gross active return, often leading to underperformance compared to passive alternatives.⁷,⁶ Studies have shown that, on average, actively managed funds frequently underperform comparable passive index funds over longer periods, with higher costs being a significant contributing factor.⁵,⁴
• Survivorship Bias: Performance analysis can be skewed by survivorship bias, where only successful funds remain in data sets, making the average active return appear higher than it truly is for all funds that initially existed. Funds that underperform often merge or close.
• Difficulty of Consistent Outperformance: Generating consistent positive active return is challenging. In efficient markets, information is quickly incorporated into prices, making it difficult for active managers to consistently identify mispriced assets and achieve superior returns after accounting for costs. The debate on whether market efficiency allows for persistent active outperformance remains a central theme in finance.³,²,¹

Active Return vs. Passive Return

Active return specifically quantifies the additional gain or loss attributable to a manager's specific investment decisions beyond a benchmark. In contrast, passive return refers to the return generated by an investment strategy that aims to replicate the performance of a specific market index.

The key distinction lies in the underlying investment philosophy. Active management seeks to outperform a benchmark by making discretionary choices about what to buy and sell, based on research and market insights. This pursuit of outperformance is directly measured by active return. Passive management, conversely, does not attempt to outperform but rather to match the market's return by investing in a diversified portfolio designed to mimic an index. Therefore, a perfectly passive strategy would ideally have an active return of zero (before fees), as its goal is to replicate the benchmark precisely. Any deviation from the benchmark return in a passive fund is typically due to tracking error, transaction costs, or minor rebalancing differences, not intentional efforts to add excess return.

FAQs

Q: Is a high active return always good?
A: Not necessarily. While a high active return indicates outperformance, it's essential to consider the risk taken to achieve that return. A manager might generate high active returns by taking on excessive risk. Evaluating active return in conjunction with risk-adjusted return metrics like the Sharpe ratio or Treynor ratio provides a more complete picture.

Q: How do fees affect active return?
A: Fees and expenses directly reduce the active return received by the investor. When calculating net active return, all costs, including management fees and trading expenses, are subtracted from the portfolio's gross return. This is why a fund with high expense ratio may struggle to deliver a positive net active return even if its gross return slightly beats the benchmark.

Q: Can a passive fund have an active return?
A: In theory, a purely passive fund aims for an active return of zero, as its goal is to perfectly replicate its benchmark index. However, in practice, passive funds may exhibit small positive or negative active returns due to factors like tracking error, transaction costs, cash drag, or slight deviations in index replication, but these are generally minimal compared to actively managed funds.