Active Return: Definition, Examples, and Insights

What Is Active Return?

Active return measures the performance of an investment compared to a selected benchmark. It is calculated by taking the difference between the actual return of an investment and the return of its benchmark. Investors seek active return to evaluate whether a fund or investment manager outperforms the market. Positive active return indicates better-than-benchmark performance, while negative active return shows underperformance.

Understanding active return helps investors make informed decisions about fund performance and management style. We'll explain how fund managers attempt to achieve it by employing strategic investment techniques.

Understanding the Mechanics of Active Return

A portfolio that outperforms the market has a positive active return, assuming that the market as a whole is the benchmark. For example, if the benchmark return is 5% and the actual return is 8%, the active return would then be 3% (8% - 5% = 3%).

If the same portfolio returned only 4%, it would have a negative active return of -1% (4% - 5% = -1%).

If the benchmark is a specific segment of the market, the same portfolio could hypothetically underperform the broader market and still have a positive active return relative to the chosen benchmark. This is why it is crucial for investors to know the benchmark a fund uses and why.

Pursuing Active Returns: Strategies and Challenges

Legendary investor Warren Buffet believes most investors would achieve better returns by investing in an index fund as opposed to trying to beat the market. He believes that any active returns fund managers make get eroded by fees. Research from S&P and Dow Jones Indices supports Buffet’s thinking. Data revealed that, even if fund managers had a successful three-year record of generating active returns, they underperformed the benchmark in the following three years.

Many fund managers combine active and passive management to create a core and satellite strategy that maintains core holdings in a diversified index fund to minimize risk while also actively managing a satellite component of the portfolio to try to outperform a benchmark.

Effective Strategies for Achieving Active Returns

Fund managers who are seeking active returns try to detect and exploit short-term price movements by using fundamental and technical analysis. For example, a manager may create a portfolio that consists of stocks that have a low debt-to-equity ratio and pay a dividend yield above 3%. Another manager may buy stocks that have formed an inverse head and shoulders reversal chart pattern. Fund managers also closely follow trading patterns, news, and order flow in their endeavor to achieve active returns.