What is Abnormal Return?

What is Abnormal Return?

An abnormal return describes the unusually large profits or losses generated by a given investment or portfolio over a specified period. The performance diverges from the investments’ expected, or anticipated, rate of return (RoR)—the estimated risk-adjusted return based on an asset pricing model, or using a long-run historical average or multiple valuation techniques.

Returns that are abnormal may simply be anomalous or they may point to something more nefarious such as fraud or manipulation. Abnormal returns should not be confused with “alpha” or excess returns earned by actively managed investments.

Abnormal Return Formula

It is represented as below,

Abnormal Return Formula = Actual Return – Expected Return

How do Abnormal Returns Happen?

With abnormal returns, you can find the risk-adjusted performance of a portfolio in relation to usual market standards and benchmark indexes. Hence, you can know whether your investments are sufficiently compensated for the risk you are assuming.

An abnormal return is obtained by subtracting actual returns from the forecasted ones, and thus, can be positive or negative. A mutual fund with 12% average return expected a year, if delivers 26% return, it implies 14% abnormal return.

On the contrary, if it actually gave 3% return, you will get negative 9% anomaly return. The Capital Asset Pricing Model (CAPM) determines the expected return rate for a specific portfolio or security, considering risk-free returns, expected market returns and beta.

Once you determine expected income, you can determine abnormal income by subtracting expected yield from realized return rate. Abnormal returns are dependent on the securitys or portfolios performance.

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For instance, consider a risk-free return 2% and benchmark return as 15%. Now if you want to know the abnormal income of your portfolio for the last year, then relative to the benchmark index, your portfolio is carrying 1.25 beta and 25% return. Hence, taking into an account the risk, your portfolio must give 18.25% return , implying your abnormal return rate of last year as 6.75%. The same procedure is applied for the stocks.

Importance of Abnormal Returns

Abnormal returns allow investors to track the performance of an individual asset or a portfolio of assets relative to a certain benchmark, which is usually set using the CAPM equation. By accounting for the market return as a benchmark, abnormal returns allow investors to measure the true extent of profits and losses.

The figures are also used to measure the financial impact of mergers, lawsuits, product launches, organizational changes, and other events that affect the price of a company’s stock.

Cumulative Abnormal Return (CAR)

Cumulative abnormal return (CAR) is the total of all abnormal returns. Usually, the calculation of cumulative abnormal return happens over a small window of time, often only days. This short duration is because evidence has shown that compounding daily abnormal returns can create bias in the results.

Cumulative abnormal return (CAR) is used to measure the effect lawsuits, buyouts, and other events have on stock prices and is also useful for determining the accuracy of asset pricing models in predicting the expected performance.

The capital asset pricing model (CAPM) is a framework used to calculate a security or portfolio’s expected return based on the risk-free rate of return, beta, and the expected market return. After the calculation of a security or portfolio’s expected return, the estimate for the abnormal return is calculated by subtracting the expected return from the realized return.

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Example of Abnormal Returns

An investor holds a portfolio of securities and wishes to calculate the portfolio’s abnormal return during the previous year. Assume that the risk-free rate of return is 2% and the benchmark index has an expected return of 15%.

The investor’s portfolio returned 25% and had a beta of 1.25 when measured against the benchmark index. Therefore, given the amount of risk assumed, the portfolio should have returned 18.25%, or (2% + 1.25 x (15% – 2%)). Consequently, the abnormal return during the previous year was 6.75% or 25 – 18.25%.

The same calculations can be helpful for a stock holding. For example, stock ABC returned 9% and had a beta of 2, when measured against its benchmark index. Consider that the risk-free rate of return is 5% and the benchmark index has an expected return of 12%. Based on the CAPM, stock ABC has an expected return of 19%. Therefore, stock ABC had an abnormal return of -10% and underperformed the market during this period.

Conclusion

To sum up, we can say that Abnormal return is most important, a measure which can help in gauging the performance of the portfolio manager and the correctness of his insights of market movement.

This further gives asset management companies Asset Management Companies An Asset Management Company (AMC) refers to a fund house, which pools money from various sources and invests the same in purchasing capital on behalf of their investors.