Active Return

It is the difference between the actual return on a portfolio and its benchmark

Author: Austin Anderson
Austin Anderson
Austin Anderson
Consulting | Data Analysis

Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager. At EY, he focuses on strategy, process and operations improvement, and business transformation consulting services focused on health provider, payer, and public health organizations. Austin specializes in the health industry but supports clients across multiple industries.

Austin has a Bachelor of Science in Engineering and a Masters of Business Administration in Strategy, Management and Organization, both from the University of Michigan.

Reviewed By: Christopher Haynes
Christopher Haynes
Christopher Haynes
Asset Management | Investment Banking

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds asset management firm with $20 billion under management, and as an investment banking analyst in SunTrust Robinson Humphrey's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Last Updated:October 26, 2023

What is the Active Return of a Portfolio?

Active Return is the measure of how well an investment portfolio is doing compared to a standard benchmark. This metric is used by investors and financial analysts to determine the performance of their investments better.

Now, when it comes to managing risks in your investment portfolio, there are two common practices that investors use to manage their portfolio risk, which are known as diversification and asset allocation. Diversification means spreading your investments across different types of assets to reduce risk, and asset allocation is deciding how much of your money goes into different categories like stocks, bonds, or real estate to balance your risk and return.

Additionally, the Capital Asset Pricing Model (CAPM) can be thought of as an important tool in determining this type of return due to its provision of techniques for calculating and justifying it. In the context of CAPM, a portfolio's investment benchmark denotes a consensus market portfolio.

This type of return is different from passive return because it doesn't require an active management team and seeks to replicate an already existing market index. 

Key Takeaways

  • Active return is the portfolio's actual performance minus its benchmark, indicating how well it outperforms or lags behind the market.
  • Diversification spreads investments, while asset allocation balances investment types, both crucial for managing portfolio risk.
  • Active return can be calculated by subtracting benchmark return from actual return shows if a portfolio overperforms or underperforms.
  • CAPM measures systemic risk. Passive investing means holding a benchmark index, avoiding active trading, and aiming for steady, long-term growth.
  • Active management involves strategic trading to outperform, while passive management replicates a chosen index for lower costs

Understanding the Active Return

It is the percentage gain or loss in comparison to the benchmark of an investment. A benchmark could be industry-specific, like the Dow Jones U.S. Financials Index, or market-wide, like the Standard and Poor's 500 Index (S&P 500).

The percentage of returns (profit or loss) in a portfolio of investments that can be directly linked to the active management choices made by the portfolio manager is known as the "active return." 

It is calculated by subtracting from the benchmark the investment return brought on by general market movements. If the actual return exceeds the market index, the fund is said to have generated a positive active return.

If the fund's performance falls short of the returns of the market index, the market will have a negative active return and be considered to have underperformed. The benchmark is the return that an investor might get by selecting a passive investing strategy.

The active return is the difference between the active return and the benchmark return. It is frequently used to evaluate performance and can be either positive or negative. 

Asset management companies or hedge funds are typically "active fund managers," companies that seek this type of return.

Using fundamental and technical research, fund managers that are looking for active returns strive to identify and take advantage of short-term market fluctuations. 

For instance, a portfolio manager could choose to invest in firms with low debt-to-equity ratios and dividend yields above 3%. Stocks that have developed an inverse head and shoulders reversal chart pattern may be purchased by different management. 

Fund managers also pay close attention to trading trends, news, and order movement to achieve this kind of return.

Many fund managers mix active and passive management to develop the core and satellite approach, which keeps core holdings in a diversified index fund to reduce risk while actively managing a satellite component of the portfolio to aim to exceed a benchmark.

Active Return Calculations

The formula for finding it can be visually interpreted as follows:

Active Return = Actual Return - Benchmark Index 

For instance, if the benchmark index is 5% and the actual return is 5.5%, using the above formula, the active return would be 0.5%.

Furthermore, the return can also be negative. For example, if the benchmark index is 5%, and the actual return comes out to be 4%, the active return would be -1%. 

By comparing the returns to benchmark performance, fund managers or investors may quickly determine if the portfolio has outperformed or underperformed. 

In accordance with the prior example, the portfolio has outperformed if the returns are positive. In contrast, the portfolio underperformed if the returns were negative.

If the benchmark changes, the overperformance and underperformance may also alter. It is possible for the same portfolio to be in the over-performance zone for one benchmark while being in the under-performance zone for another. 

As a result, the benchmark index employed as a foundation totally determines whether performance is good, negative, or both. This benchmark is chosen by the asset management firm and the fund manager when they solicit investor subscriptions.

Diversification Strategy 

This concept reforms the professional management of assets, including stocks, bonds, derivatives, and other assets like real estate, for both individuals and businesses. 

A portfolio manager is in charge of managing a portfolio and will take the investor's risk tolerance and investment objectives into account.

Portfolio management can include complex financial procedures such as financial analysis, monitoring, reporting, and asset appraisal. The ultimate objective of portfolio management is to maximize projected returns, given the degree of risk exposure. 

Diversification is the process of allocating funds among several investments to lower risk. Put simply, the approach of diversification is to "Don't put all your eggs in one basket."

Investing in various assets is one way to diversify one's portfolio. It is known that cash, bonds, and equities have never fluctuated up and down simultaneously in the past. 

When one asset class performs poorly, other asset classes may benefit from the same factors. People make investments across a range of asset classes with the anticipation that if one is losing money, the others will make up for it.

If an investor spreads out his or her assets within each asset class, their diversification will also be better. This entails holding a variety of stocks and bonds and making investments in many business areas, including consumer products, healthcare, and technology. With other assets in sectors that are performing well, you may balance out a sector's performance if it is performing poorly.

Additionally, owning mutual funds can make diversification simpler for certain investors. A corporation that combines money from several people and invests it in stocks, bonds, and other financial goods is known as a mutual fund. 

Owning a modest percentage of several investments is made simple for investors by mutual funds. For instance, a complete stock market index fund owns equity in hundreds of businesses, offering significant financial diversity.

Asset Allocation Strategy

Spreading out one’s investment reduces exposure to any one form of asset. Having only one form of asset in one’s portfolio increases risk.

If that asset were to lose value, so would the investor because he or she has nothing to offset that loss and lessen the volatility of returns on a portfolio. 

Learning how to strike a balance between the degree of comfort with risk and an investor's time horizon is one of the keys to a successful investment. 

For instance, some investors find that if they invest in their retirement savings too cautiously when they're young, they face the danger of their investments' growth outpacing inflation.

The opposite can also be true: if one invests too aggressively as they become older, they risk leaving their funds vulnerable to market fluctuations, which might depreciate assets at a time when they have fewer possibilities to make up for their losses. 

The key to a successful portfolio is to have different kinds of asset classes, and some of those include:

1. Domestic stocks

These should represent the most aggressive component of the portfolio and provide opportunities for high long-term growth. 

However, there is a higher risk associated with this increased growth potential, especially in the short term. A stock investment may lose value if and when one decides to sell it since equities are often more volatile than other kinds of investments.

2. Bonds

Most bonds pay out interest on a consistent basis and are seen to be less volatile than equities. They frequently perform differently than equities, which can provide a buffer against the unexpected ups and downs of the stock market.

3. International stocks 

The performance of stocks issued by non-US corporations frequently differs from that of their US-issued equivalents, giving investors access to possibilities not available in US equities. 

Investors should consider including some foreign equities in their portfolio if they're looking for assets with both larger potential rewards and higher risk.

4. Short-term investments 

These include short-term CDs and money market funds (certificates of deposit). Money market funds are conservative investments that provide stability and convenient money access, making them the best choice for investors who want to protect their principal. 

Money market funds often offer lower returns than bond funds or individual bonds in exchange for that degree of safety.

Active return and CAPM

The link between systemic risk, or the overall dangers of investing, and the expected return for assets, particularly equities, is described by the Capital Asset Pricing Model (CAPM).

The CAPM was created as a tool to quantify this systemic risk. It is frequently used in the financial industry to value hazardous securities and calculate projected returns for assets given their risk and cost of capital.

CAPM offers methods for measuring and defending active return and is frequently explored. A portfolio's investment benchmark in the context of CAPM indicates a consensus market portfolio.

A fraction (beta) of the excess return of the market portfolio (M) and a residual return can be used to deconstruct all portfolio and asset returns over a risk-free cash interest rate (referred to as "excess returns"). 

According to the CAPM, all projected portfolio and asset returns are equal to their share (or beta) of the return of the market portfolio under specific assumptions, and the expected residual return is assumed to be zero.

Passive asset management 

By reducing the amount of purchasing and selling, passive investing seeks to optimize returns. One popular passive investment technique is index investing, whereby investors buy a representative benchmark, like the S&P 500 index, and hold it for an extended period of time.

Passive investing strategies avoid the expenses and subpar returns that may be associated with frequent trading. The objective of passive investing is to increase wealth gradually.

Passive investing is the practice of purchasing a security with the intention of holding it for an extended period of time. In contrast to active traders, passive investors don't try to time the market or profit from quick price changes. 

The fundamental tenet of a passive investment strategy is that the market consistently generates profits.

In general, passive managers attempt to replicate market or sector performance since they don't think it's possible to outsmart the market.

By building well-diversified portfolios of individual equities, which, if done individually, would require substantial research, passive investing aims to imitate market performance. 

Achieving returns in line with the market was much simpler after index funds were introduced in the 1970s.

Exchange-traded funds, or ETFs that follow important indexes, such as the SPDR S&P 500 ETF (SPY), streamlined the procedure even more in the 1990s by enabling investors to trade index funds like stocks.

Active vs. Passive Asset Management

When it comes to investing, there are two primary strategies that are used by investors, which are known to aid in producing a higher yield. 

In an active asset management method, the portfolio manager decides how the money will be invested. 

By purchasing and selling securities like stocks, futures contracts, and options contracts on the open exchange markets, the manager seeks to exceed the benchmark index, such as the S&P 500.

To decide whether to purchase or sell a particular asset, the management considers market trends, economic statistics, and the most recent company-specific news.  In order to outperform fund managers that duplicate the security holdings stated on an index, the managers put their judgments into action.

Active management cannot make decisions in passive asset management. Essentially, it concentrates on emulating the asset allocations of a certain market index.

In order to produce outcomes that are equal to the chosen index, it creates an investment that is similar to it and uses the same weighting. 

Due to low turnover rates and the absence of an active management team that would otherwise be compensated with management fees, passively managed funds have lower expenses than actively managed funds.

Active Return FAQs

Researched and authored by Anja Corbolokovic Linkedin 

Uploaded and revised by Omair Reza Laskar LinkedIn

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