Excess return is the additional return on an investment over a baseline earnings rate. Depending on the situation, the baseline rate may be the risk-free rate. For example, if the return on an investment is eight percent and the risk-free rate is two percent, then the excess return is six percent. The risk-free rate is derived from the return on U.S. Government securities.
The excess return concept can be used to develop a compensation arrangement for a fund manager, where the manager is only paid if he or she can generate a return that is greater than a benchmark rate, such as the rate that would be earned by an index fund. In this case, the excess return is the value generated by the fund manager.