Active return refers to the additional return an investor earns by actively managing a portfolio, compared to a benchmark index or passive investment strategy. It reflects the performance attributable to active decisions such as stock selection, timing, or asset allocation made by the portfolio manager.

Understanding active return is vital for evaluating the effectiveness of active management in achieving higher returns than simply following the market. Below, we break down its meaning, challenges, and how to calculate it.

Understanding Active Return

Active return is the difference between the portfolio’s actual return and the return of its chosen benchmark. For example, if a mutual fund achieves a 10% annual return while its benchmark index delivers 7%, the active return is 3%. This measure helps investors assess whether the portfolio manager’s strategies are adding value.

Active return is often linked to alpha in investment performance. A positive active return indicates successful active management, while a negative active return suggests underperformance relative to the benchmark.

Common Challenges Related to Active Return

1. Benchmark Selection: Choosing an appropriate benchmark is critical. An inaccurate benchmark can distort the active return calculation.
2. Market Efficiency: In highly efficient markets, achieving consistent active return is challenging, as most information is already reflected in asset prices.
3. Costs of Active Management: Management fees, transaction costs, and taxes can erode the active return.
4. Risk Management: Generating active return often involves taking additional risks, which may not always lead to favourable outcomes.

Step-by-Step Solutions for Calculating Active Return

To calculate active return, follow these steps:

1. Determine Portfolio Return: Identify the actual return of the actively managed portfolio over a specific period.
2. Identify the Benchmark Return: Select an appropriate benchmark index and calculate its return over the same time period.
3. Subtract Benchmark Return: Subtract the benchmark’s return from the portfolio’s return to get the active return.
   Formula:
   Active Return = Portfolio Return − Benchmark Return Example:
   • Portfolio Return: 12%
   • Benchmark Return: 8%
   • Active Return = 12% − 8% = 4%
4. Evaluate Performance: Analyse whether the active return justifies the additional costs and risks involved in active management.

Practical and Actionable Advice

• Choose an Appropriate Benchmark: Ensure the benchmark aligns with the portfolio’s objectives and asset mix.
• Monitor Costs: Keep management fees and transaction costs low to maximise active return.
• Assess Risk-Adjusted Returns: Use metrics like the Sharpe ratio or information ratio to evaluate whether the active return is worth the risk.
• Consistency Over Time: Focus on sustained active return rather than one-off outperformance.

FAQs

What is the purpose of active return?
Active return measures the value added by portfolio managers through active investment decisions compared to passive strategies.

How is active return different from total return?
Active return isolates performance due to active management, while total return includes all gains and losses from the portfolio, including the market component.

Can active return be negative?
Yes, a negative active return occurs when the portfolio underperforms its benchmark.

What are common benchmarks used in calculating active return?
Benchmarks vary by asset class, such as the S&P 500 for US equities or the FTSE 100 for UK stocks.

Is active return the same as alpha?
Active return is closely related to alpha but does not consider risk adjustment. Alpha accounts for excess return after adjusting for market risk.

Why is selecting the right benchmark important?
The benchmark serves as the performance standard. An inappropriate benchmark may misrepresent the portfolio’s success or failure.

How does risk affect active return?
Higher risks taken to generate active return can lead to greater volatility and potential losses.

What factors contribute to active return?
Factors include stock selection, market timing, and asset allocation strategies.

Are active returns guaranteed?
No, active returns depend on market conditions and the effectiveness of the portfolio manager’s strategies.

What is a good active return?
This depends on the portfolio’s goals and risk tolerance. Consistent active returns above the benchmark, after accounting for fees, are typically considered favourable.

Conclusion

Active return is a critical measure for evaluating the effectiveness of active portfolio management. It highlights the portfolio manager’s ability to outperform a chosen benchmark through strategic decisions. By understanding the challenges and applying the proper calculation methods, investors can make informed decisions about the value of active management.