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What is an Active Return?

Jim B.
Jim B.

An active return on an investment is any return that outperforms the expected return of the investment as determined by past performance. While the term may be used concerning any particular investment, it is usually reserved for discussions of investors' portfolios. To achieve an active return, it is normally necessary for an investor to assume a degree of risk that is higher than normal. Investors usually take on this risk by creating some sort of deviation from the usual investment strategies used by other investors.

Many investors have different ideas for what they want out of an investment portfolio, which is the variety of securities in which investment capital is placed. Some may simply want their investment capital to be protected so they can have it at their disposal at a time in their life when they can no longer earn much income. Others may want to be more aggressive, seeking to receive above and beyond what the market is expected to yield. This latter group of people is seeking an active return on their investment.

Man climbing a rope
Man climbing a rope

As an example of this theory, imagine that an investor has a portfolio that, under normal circumstances, would be expected to achieve a rate of return of approximately 5 percent in a single year. At the end of a year, the portfolio has appreciated in value by 7 percent over the previous year. In this case, the benchmark return of 5 percent is subtracted from the 7 percent actual return. Thus, the active return for this portfolio is 2 percent.

No investor can hope to achieve an active return without trying to deviate somewhat from the strategies that produce benchmark returns. An investor might try to make slight adjustments to the benchmark by adding stocks with potential and dropping a few that might be bound to struggle. On the other hand, an investor might completely ignore the normal strategy, seeking to benefit from securities currently being ignored by the majority of investors.

In either case, pursuing an active return usually means accepting a bit more risk into an investment strategy. The more aggressively that an investor seeks a return above what the market usually yields, the more likely it is that his portfolio can suffer significant losses. Before an investor goes after significant returns, he needs to identify what his acceptable risk might be. That depends on the goals he has for his portfolio and what purpose the capital within it will eventually serve in his life.

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