Active return refers to the difference between the returns of an investment portfolio and its benchmark index over a specific period. It measures the value added (or lost) by an active manager’s investment decisions compared to a passive benchmark. Active return is a critical metric for evaluating the performance of actively managed portfolios and assessing the effectiveness of investment strategies.

Understanding Active Return

The formula for calculating active return is:
Active Return = Portfolio Return – Benchmark Return

For example:

• A portfolio generates a return of 8% over a year.
• The benchmark index returns 5% during the same period.
• Active return = 8% – 5% = 3%.

A positive active return indicates that the portfolio outperformed the benchmark, while a negative active return suggests underperformance.

Importance of Active Return

• Performance Evaluation: Measures how well a portfolio manager’s strategies perform relative to a benchmark.
• Risk Assessment: Helps determine if the portfolio’s higher return justifies the additional risk taken.
• Investor Decision-Making: Guides investors in selecting actively managed funds or portfolios.
• Accountability: Provides a transparent way to evaluate an investment manager’s effectiveness.

Factors Influencing Active Return

1. Stock Selection: The choice of specific securities within the portfolio.
2. Asset Allocation: The distribution of investments across asset classes, sectors, or regions.
3. Timing Decisions: The ability to buy or sell at favourable times.
4. Risk Management: Strategies to mitigate potential losses while pursuing higher returns.

Common Challenges Related to Active Return

• Market Volatility: Short-term fluctuations can distort active return calculations.
• Benchmark Selection: Choosing an inappropriate benchmark may lead to misleading comparisons.
• Costs and Fees: Active management fees can erode the active return.
• Sustainability: Consistently generating positive active returns over time is challenging.

Step-by-Step Guide to Measuring and Using Active Return

1. Select a Benchmark: Identify a benchmark that closely aligns with the portfolio’s objectives and asset allocation.
2. Calculate Portfolio Returns: Determine the portfolio’s total return, including dividends and capital gains.
3. Calculate Benchmark Returns: Obtain the total return of the chosen benchmark.
4. Find the Difference: Subtract the benchmark return from the portfolio return to calculate the active return.
5. Analyse Results: Assess whether the active return justifies the associated risks and fees.

Practical and Actionable Advice

• Choose the Right Benchmark: Ensure the benchmark accurately reflects the portfolio’s investment style and risk profile.
• Track Over Time: Monitor active return over multiple periods to identify trends and consistency.
• Consider Risk-Adjusted Metrics: Use metrics like the Sharpe Ratio or Information Ratio alongside active return to assess performance.
• Focus on Net Return: Evaluate active return after accounting for management fees and trading costs.
• Avoid Short-Term Bias: Analyse long-term active return to account for market cycles and volatility.

FAQs

What is active return?
Active return is the difference between a portfolio’s return and its benchmark’s return, measuring the value added by active management.

How is active return calculated?
Active Return = Portfolio Return – Benchmark Return.

Why is active return important?
It evaluates a portfolio manager’s ability to outperform a benchmark and adds accountability to active management.

What is a good active return?
A good active return depends on the portfolio’s risk level and objectives, but it should exceed the costs of active management.

Can active return be negative?
Yes, a negative active return indicates underperformance compared to the benchmark.

What factors influence active return?
Stock selection, asset allocation, timing decisions, and risk management all impact active return.

How does active return differ from total return?
Total return measures the overall performance of an investment, while active return measures performance relative to a benchmark.

What role do fees play in active return?
High fees can reduce net active return, making it essential to evaluate performance after accounting for costs.

Can active return be used for passive investments?
No, active return is specifically used to measure the performance of actively managed portfolios.

How can I improve active return?
Focus on effective stock selection, optimal asset allocation, and minimising costs to enhance performance.

Conclusion

Active return is a crucial metric for measuring the effectiveness of actively managed portfolios relative to their benchmarks. By highlighting the value added (or lost) through investment decisions, active return provides valuable insights for both investors and portfolio managers. To maximise its benefits, it’s important to use appropriate benchmarks, monitor trends over time, and account for associated costs and risks.