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.
In order to generate an excess return, it is likely that an investor will have to take on additional risk of loss; this is under the assumption that an increased rate of return equates to more risk.