Using Underperformance Risk to Determine Excess Return: The Case of US Equity

This article deals with excess returns and the underperformance risk related to them. We interpret the standard ex post tracking error as an underperformance (active) risk associated specifically with excess returns. The contribution is not a new statistic but a pricing and allocation framework that treats the benchmark return as the reference point for the active component, enabling a capital asset pricing model–consistent separation of market and active risks. Then we tested its properties on a large sample of investments from the US large-cap equity segment. The initial analysis indicates that the underperformance risk retains normal distribution and is significantly different from the overall market risk. It also illustrates its practical tangibility, as a notable proportion of the active managers in our sample regularly underperforms the market (index) portfolio. The new risk metric was found to be an efficient predictor of the active manager’s future performance. It provides a higher correlation with prospective excess returns and explains a far greater deal of their variability than the overall market risk does with the overall returns. This paves the way to potentially higher returns than the market index, when the underperformance risk is utilized as an auxiliary allocation criterion.