Active returns

What Is Active Returns?

Active returns refer to the excess returns generated by an investment portfolio compared to its designated benchmark. Within the realm of portfolio performance measurement, active returns quantify the value added or subtracted by an investment manager through their investment decisions, as opposed to simply tracking a market index. It is often synonymous with alpha, representing the portion of a portfolio's return that cannot be attributed to the overall market's movement. Investors seek positive active returns from their investment management strategies, indicating that the manager has successfully identified undervalued assets or avoided overvalued ones.

History and Origin

The concept of active returns is intrinsically linked to the ongoing debate between active and passive investment strategies. While active management has existed as long as professional money management, the formalization of analyzing active returns gained prominence with the development of modern portfolio theory in the mid-20th century. A significant turning point came with the work of economists like Eugene Fama and the articulation of the efficient market hypothesis (EMH). Fama, who shared the Nobel Prize in Economic Sciences in 2013 for his work on asset prices, posited that in an efficient market, all available information is already reflected in asset prices, making it exceedingly difficult for active managers to consistently "beat the market" and generate positive active returns over the long term.⁷, ⁸, ⁹ This theoretical challenge spurred deeper analysis into how and why some managers might achieve active returns, and whether such outperformance is attributable to skill or mere chance.

Key Takeaways

• Active returns measure the excess performance of an investment portfolio relative to its benchmark.
• They reflect the value added or subtracted by an active fund manager's decisions.
• Positive active returns indicate outperformance, while negative active returns signify underperformance.
• Achieving consistent positive active returns is a significant challenge due to market efficiency and costs.
• Active returns are a key component in evaluating the effectiveness of active investment strategies.

Formula and Calculation

The calculation of active returns is straightforward, representing the difference between the actual return of a portfolio and the return of its benchmark.

The formula is:

$\text{Active Returns} = \text{Portfolio Return} - \text{Benchmark Return}$

Where:

• Portfolio Return: The total percentage gain or loss of the investment portfolio over a specific period.
• Benchmark Return: The total percentage gain or loss of the chosen market index or comparative standard over the same period.

For example, if a portfolio generates a return of 12% in a year and its benchmark returns 10% in the same period, the active return would be 2%. Conversely, if the portfolio returned 8% against a 10% benchmark, the active return would be -2%.

Interpreting Active Returns

Interpreting active returns involves more than just looking at a single number; it requires context regarding the associated risk taken and the fees incurred. A positive active return suggests that the portfolio manager's stock selection, market timing, or sector allocation decisions successfully outperformed the market. However, it's crucial to assess whether this outperformance was achieved by taking on significantly higher levels of risk than the benchmark, which might be undesirable. Metrics like risk-adjusted return help provide a more holistic view. Additionally, the magnitude of active returns should be weighed against the expense ratio and other costs of the actively managed fund; high fees can erode any potential active returns, making it challenging to outperform a low-cost passive alternative on a net-of-fees basis.

Hypothetical Example

Consider an investor, Sarah, who has an investment portfolio managed by "Growth Maximizers Inc." for the calendar year. Growth Maximizers Inc. states that their primary benchmark is the S&P 500 Index.

At the end of the year:

• Sarah's portfolio with Growth Maximizers Inc. had a return of 15.0%.
• The S&P 500 Index (the market standard) had a return of 12.5%.

To calculate the active return for Sarah's portfolio:

Active Returns = Portfolio Return - Benchmark Return
Active Returns = 15.0% - 12.5%
Active Returns = 2.5%

In this hypothetical example, Growth Maximizers Inc. generated a positive active return of 2.5% for Sarah's portfolio, indicating that their active management decisions added value beyond what a passive investment in the S&P 500 would have provided.

Practical Applications

Active returns are a critical metric used across various facets of finance. In performance attribution analysis, active returns are broken down to understand what specific decisions (e.g., sector allocation, stock selection, country allocation) contributed to or detracted from performance relative to the benchmark. This helps investors and consultants evaluate the skill set of a portfolio manager. For institutional investors and financial advisors, consistent positive active returns are often a key criterion in manager selection for actively managed funds, including mutual funds and actively managed exchange-traded funds. Reports like the Morningstar Active/Passive Barometer and the S&P Dow Jones Indices SPIVA Scorecard regularly publish data comparing the success rates of active managers in generating positive active returns against their benchmarks across different asset classes and time horizons.³, ⁴, ⁵, ⁶ These reports are widely used by investors to assess the likelihood of active management success.

Limitations and Criticisms

Despite its appeal, the pursuit of active returns faces significant limitations and criticisms. A primary challenge is the difficulty of consistently generating positive active returns over extended periods, particularly after accounting for fees and trading costs. Data from reports such as the SPIVA Scorecard consistently show that a significant percentage of actively managed funds underperform their passive benchmarks over various time horizons, a trend often attributed to the inherent challenges posed by the efficient market hypothesis.¹, ² Higher transaction costs and higher management fees associated with active management can erode any gross active returns achieved. Furthermore, "performance persistence," or the ability of a manager to continue outperforming, has been shown to be elusive, suggesting that past success does not guarantee future active returns. This makes manager selection challenging, as investors may choose a fund based on historical outperformance that does not continue. The concept of tracking error also plays a role, as active managers who deviate significantly from their benchmark in pursuit of active returns may expose investors to unintended risks.

Active Returns vs. Passive Returns

Active returns represent the excess performance over a benchmark, while passive returns (or benchmark returns) are simply the returns of the underlying market index that a passive investment strategy seeks to replicate.

The confusion often arises because both describe aspects of investment performance. However, active returns specifically measure the success of an active strategy in diverging positively from its reference point, whereas passive returns describe the performance achieved by simply mirroring that reference point through passive investing.

FAQs

Can all actively managed funds generate positive active returns?

No, not all actively managed funds generate positive active returns. Many struggle to consistently outperform their benchmarks, especially after accounting for all fees and expenses.

Why is it difficult to achieve consistent positive active returns?

It is difficult due to several factors, including market efficiency, which implies that new information is quickly reflected in prices, making it hard to find undervalued assets. High fees and trading costs associated with active management also significantly impact net returns.

What is the difference between active returns and total returns?

Total returns measure the overall percentage change in an investment's value over a period, including capital appreciation and income, without reference to a benchmark. Active returns specifically measure the portion of that total return that is above or below a benchmark's return.

How do active returns relate to the Sharpe Ratio?

The Sharpe ratio is a measure of risk-adjusted return. While active returns quantify raw outperformance, the Sharpe ratio helps evaluate if that outperformance was worth the level of risk taken. A higher Sharpe ratio indicates better risk-adjusted returns, which can be achieved through positive active returns without excessive risk.

Are active returns relevant for a diversified portfolio?

Yes, active returns are relevant even for a diversified portfolio if some of its components are actively managed. Investors should evaluate whether the actively managed segments are indeed contributing positive active returns to the overall portfolio's performance, justifying their higher costs compared to passive alternatives.