An abnormal return refers to the unexpectedly high earnings or losses a portfolio or investment yielded over a certain period. The results deviate from the rate of returns (RoR) expected for the investments, which is the expected risk-adjusted returns calculated using an asset price model, a long-term historical average, or various valuation methods.
Unexpected returns could be aberrant or a sign of fraud or other criminal activity. It's important to distinguish between abnormal returns and excess returns or "alpha" from actively managed investments.
Abnormal Returns Explained
Abnormal returns are important in evaluating the risk-adjusted returns of an asset or portfolio in comparison to a benchmark index or the overall market. Depending on risk-adjusted performance, investors can use abnormal returns to determine the skills of a portfolio manager. Additionally, it will show if investors were fairly compensated for the degree of investment risk they assumed. For example, investors can use the Nifty Bank Index to assess a portfolio of Indian banking corporations. In contrast, they can use the S&P 500 Index to analyze a portfolio of U.S. large-capital stocks.
Positive or negative returns can both be considered abnormal returns. Simply said, abnormal returns show how the actual return compares to the expected return. For instance, earning 40% in a mutual fund with a projected average annual return of 15% would result in a 25% positive abnormal return. On the other hand, if the actual return, in this case, were 5%, it would result in a negative abnormal return of 10%.
Cumulative Abnormal Returns (CAM)
The sum of all abnormal returns is known as the cumulative abnormal return or CAR. The determination of the CAR often occurs over a little time, usually just a few days. The reason for selecting this small period is that the evidence suggests that accumulating regular abnormal returns may skew results.
CAR is a valuable metric for assessing how correct asset valuation models predict future performance and is used to quantify the effect of buyouts, lawsuits, and other events on stock prices.
In some circumstances, stock prices may fluctuate in response to the social media activities of a firm's top management. For instance, in 2018, when Tesla CEO Elon Musk posted that he was thinking about taking the firm private at $420 per share, Tesla's stock (NASDAQ: TSLA) fell in value, and trading in the shares was halted for a few days.
The Capital Asset Pricing Model, or CAPM, is a concept used to evaluate the expected return of a portfolio or an asset depending on the beta, expected market return, and the risk-free rate of returns (RoR). The calculation for the abnormal return is produced by subtracting the expected rate of return from the actual return after assessing the expected return for an asset or a portfolio.
Abnormal Return Formula
The formula to calculate abnormal returns is
Abnormal return = Actual Return - Expected Return
Abnormal Return Example
An investor owns a security portfolio and wants to evaluate the abnormal return of the portfolio over the previous year. Suppose the benchmark index is predicted to earn 10% while the risk-free return rate is 4%.
Comparing the investor's portfolio to the benchmark index, it had a beta of 1.05 and a 20% return. As a result, the portfolio must have yielded 10.3%, or (4% + 1.05 x (10% - 4%), given its risk level. As a result, the abnormal return for the prior year was either 9.7% or 20 - 10.3%.
Financial disclosures also generate abnormal returns. For instance, the stock price of Spotify (NASDAQ: SPOT) dropped at the beginning of February 2020, when the company reported a significantly higher loss than expected.
Importance of Abnormal Returns
Performance Attribution Indicator: Abnormal return is directly impacted by the stock selection of a portfolio manager. Therefore, this tool is crucial for comparing their performance to the relevant benchmark and, as a result, for figuring out their skill level and performance-based income.
Buffer against harmful divergence: Abnormal returns may be detrimental if they fall short of expectations. Because it shows poor stock selection, if this is true for several periods, it should serve as an indicator to reduce the dispersion from the benchmark index.
Quantitative Analysis: As it is easy to calculate an abnormal return, it is a popular metric in the investment industry. However, determining the correct estimates of the CAPM model's inputs is a complex task because it needs regression analysis to assess beta and carefully observe the returns of the previous market index. After predicting these estimates correctly, they undergo detailed quantitative analysis and are, therefore, reliable.
Time Series Analysis: The cumulative abnormal return (CAR) assesses the impact of corporate management, such as dividend payments or shareholdings, on stock prices and returns. Furthermore, it helps analyze the impacts of external factors, such as cases in which some company liabilities depend, like the outcome of a court case or litigation.
Bottom Line
Summing up, abnormal return is an essential metric for assessing the performance of a portfolio manager and the accuracy of his market movement predictions. Additionally, because it can be either positive or negative, it can show when the deviation from the market index is ineffective and has to be reduced for the portfolio's best performance.
