Excess return is an important concept in modern portfolio theory and investment analysis. It refers to the performance return achieved by an investment beyond that of a predetermined proxy. This proxy can vary depending on the situation, but typically comes from a close benchmark or the riskless rate. The benchmark or riskless rate being used for analysis is also referred to as the reference portfolio or point of comparison.

The magnitude of excess return is an important metric in determining the potential benefit of an investment. Alpha is a key measure of excess return that looks at the return generated by an investment over and above that of a closely similar benchmark. Alpha attempts to measure the performance outcomes of active management when the benchmark used for comparison is appropriate. Alpha can also act as an evaluation of performance between the investment and benchmark, being used as an indicator of the manager’s skill.

Excess return becomes particularly important when constructing an optimized portfolio. By calculating the expected returns, as well as expected volatilities, of various securities and asset classes, with correlation considerations, an optimal portfolio construction can be obtained. The use of excess returns, specifically alpha, helps to properly consider the active management opportunities and the potential added value such management.

Overall, excess returns are a vital concept in investment analysis and the calculation of optimal portfolios. It can be useful in determining the relative performance of different investments and whether active management can potentially be beneficial. Excess return directives, such as alpha calculations, can be used to try and obtain maximum investment performance from a portfolio.