What it is:
Excess return, also known as "alpha" or the "abnormal rate of return the portion of a security's or portfolio's return not explained by the overall market's rate of return. Rather, it is generated by the skill of the investor or portfolio manager, and is one of the most widely used measures of risk-adjusted performance.
How it works/Example:
Let's assume you are a portfolio manager who expects your client's portfolio to return 15% next year. The year goes by and the portfolio actually returns 16%. In its most basic sense, the excess return on the portfolio is 16% - 15% = 1%.
Mathematically speaking, excess return is the rate of return that exceeds what was expected or predicted by models like the capital asset pricing model (CAPM). To understand how it works, consider the CAPM formula:
r = Rf + beta * (Rm - Rf ) + excess return
r = the security's or portfolio's return
Rf = the risk-free rate of return
beta = the security's or portfolio's price volatility relative to the overall market
Rm = the market return
The bulk of the CAPM formula (everything but the excess-return factor) calculates what the rate of return on a certain security or portfolio ought to be under certain market conditions. Note that two similar portfolios might carry the same amount of risk (same beta) but because of differences in excess return, one might generate higher returns than the other. This is a fundamental quandary for investors, who always want the highest return for the least amount of risk.
Why it matters:
Excess return is a measurable way to determine whether a manager's skill has added value to a portfolio on a risk-adjusted basis. This is why it is the holy grail of investing to some.
The very existence of excess return is controversial, however, because those who believe in the efficient market hypothesis (which says, among other things, that it is impossible to beat the market) believe it is attributable to luck rather than skill; they support this idea with the fact that, over the long-term, many active portfolio managers don't make much more for their clients than those managers who simply follow passive, indexing strategies. Thus, investors who believe managers add value accordingly expect above-market or above-benchmark returns -- that is, they expect alpha.