What Is an Abnormal Return?
The abnormal return of an investment or portfolio is a measure of its out-of-the-ordinary gains or losses over a specific time frame. The actual rate of return deviates from the predicted risk-adjusted return calculated by an asset pricing model, a long-term historical average, or a combination of valuation methodologies.
Abnormal returns might be coincidences, or they could be indicators of fraud or manipulation. There is no equivalence between abnormal returns and the “alpha” or extra returns gained by active management of assets.
Understanding Abnormal Returns
The risk-adjusted performance of a security or portfolio relative to the market or a benchmark index relies heavily on out-of-the-ordinary returns. It may be possible to gauge a portfolio manager’s skill level relative to risk by looking for periods of unusually high returns. This will show if the returns investors received were commensurate with the risks they took on.
Both positive and negative abnormal returns exist. The graph is a quick snapshot of how the actual returns compare to the forecasted yield. An abnormal return of 20% would result, for instance, from a 30% gain in a mutual fund with a normal return of 10% per year. In the same example, if the actual return were 5%, the result would be a 5% abnormal loss.
Cumulative Abnormal Return (CAR)
The sum of all anomalous returns is called the cumulative abnormal return (CAR). Typically, just a few days are used to compute cumulative abnormal returns. This short time frame is because aberrant returns compounded daily might introduce bias into the final findings.
The cumulative abnormal return (CAR) is a helpful metric for evaluating the efficacy of asset pricing models in projecting future performance and quantifying the impact of events like litigation and buyouts on stock prices.
The anticipated return of a securities or portfolio may be determined using the capital asset pricing model (CAPM), which is a framework based on the risk-free rate of return, beta, and expected market return. The strange return estimate is determined by taking the difference between the predicted and actual returns on an investment or portfolio.
Example of Abnormal Returns
A portfolio investor is interested in determining the portfolio’s abnormal return for the prior year. Let’s pretend the benchmark index is predicted to yield 15% while the risk-free rate of return is 2%.
The investor’s portfolio generated a 25% return and had a beta of 1.25 relative to the market index. Therefore, the portfolio should have returned 18.25%, or (2% + 1.25 x (15-2)-2%), given the level of risk taken. This means that the abnormal return for the prior year was 6.75 percent (or 25 percent minus 18.25 percent).
For a portfolio of stocks, the same computations might be useful. ABC stock’s return was 9%, compared to its benchmark index, and its beta was 2. Considering that the benchmark index is predicted to yield 12%, the risk-free rate of return is 5%. The CAPM estimates a 19% return for ABC Stock. So, stock ABC underperformed the market with a negative abnormal return of 10%.
SUMMARY
- A non-normal return is significantly different from the average return on investment.
- Abnormal returns, which may be positive or negative, are a useful indicator of risk-adjusted performance for investors.
- Abnormal profits may arise from randomness, outside influences, or malicious intent.
- One way to quantify the impact of litigation, buyouts, and other market-moving events is by using a cumulative abnormal return (CAR), simply the sum of all abnormal returns.
