The excess return for exchange-traded funds (ETFs) should be equal to the risk-adjusted (or beta) measure that surpasses the instrument's benchmark or yearly cost ratio. It's simple to compare index mutual funds to the benchmark index: simply subtract the benchmark's total return from the fund's net asset value to calculate excess return. The excess return for an index fund is often negative due to mutual fund fees.
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| What formula is used to determine an ETF's or mutual fund's excess return? |
Investors often favor index mutual funds and ETFs that exceed their benchmarks and have positive excess returns. Due to the predominance of high fees and market unpredictability, several investors and experts feel it is nearly difficult for managed mutual funds to achieve excess returns over an extended time period. (See Index Mutual Funds vs. Index ETFs for more information.)
Calculating Excess Return for ETFs
Most ETFs, like most index mutual funds, underperform their benchmark indices. On average, ETFs outperform index mutual funds in terms of excess returns.
Consider an ETF's projected return to be its alpha for a given price and risk profile. A variety of risk metrics can be employed to match an ETF with a benchmark.
The weighted average cost of equity is a popular example. When calculating an ETF's excess return, use total return in excess of the expected return based on the capital asset pricing model (CAPM) formula if you don't have or don't want to use the annual expense ratio or a simple benchmark.
This is how the CAPM formula is expressed:
- TEFTR=RFRR+(ETFb×(MR−RFRR))+ER
where:
- TEFTR=Total ETF return
- RFRR=Risk-free rate of return
- ETFb=ETF beta
- MR=Market return
- ER=Excess return
The formula, when rearranged, appears as follows:
- ER=RFRR+(ETFb×(MR−RFRR))−TEFTR
You may compare two portfolios or ETFs with equal or very comparable risk profiles (beta) using the CAPM approach to see which generates the greatest excess returns. (See also Explaining the Capital Asset Pricing Model for more information.)
Index Funds' Excess Return Calculation
Large positive or negative excess returns relative to their index are something that index funds are made to avoid. To reduce the predicted variation from the benchmark, index fund developers employ risk-control approaches and passive management.
It is simple to calculate the excess returns of an index fund. To illustrate, compare the total returns of an S&P 500 index mutual fund to the performance of the S&P 500. It is possible, but improbable, that the indexed fund may outperform the S&P 500. The excess returns will be positive in this situation. Administrative expenses linked with mutual funds are more likely to yield a little negative excess return. What is a Good Annual Return for a Mutual Fund, for further reading in this area.
